UNIT ONE

1. Basic Concepts in Economics

Introduction

Colleague,let us start our discussion with the concept of resources in the definition of
economic science. In this section, we will first define economics; then we will look in to the
concept of scarcity and opportunity cost; and finally we will discuss production possibilities.

The world is endowed with various resources. Some are free and others are available with
cost. Economics concerns itself with the latter type of resources. Economic resources are
available in limited quantity. The problem, therefore, is finding the best way of allocating
these scarce resources.

Objectives

At the end of this section, you should be able to:

 Define economics;

 Define and distinguish between microeconomics and macroeconomics;

 Define Economic problems and Economic system

 Define scarcity, choice and opportunity cost; and

 Define the production possibility curve.

1.1.1. Definitions

How do you define economics?! Economics has been defined in different ways by different
authors. Let you compare your definition with the following more general definition:

Although there are different definitions of economics the most agreed up on one is:
Economics is the study of the efficient allocation of scarce resources (which often do have
alternative uses) in the production, distribution &consumption of goods and services, so as to attain
the maximum fulfillment of unlimited human wants or needs.
The above definition of economics clearly indicates that there are two fundamental facts which are
the foundation for the field of economics.

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  The first fact is: human wants are unlimited
 The second fact is: economic resources -the means of producing goods and services are limited
in supply or scarce.
The need to balance unlimited wants with limited resources has raised the question of efficient
utilization of scarce resources by minimizing loss or wastage.
WHY WE STUDY ECONOMICS?
The knowledge of economics is important in;
 Wisely allocating scarce resources to satisfy the unlimited human wants
 Efficiently managing your business, since it deals about price, cost, profit, market, production,
saving, investment etc.
 A better understanding of the economic problems of societies ,such as rising unemployment,
inflation, budget deficit, external debt, economic growth etc.
 Formulating different policies. Presidents and prime ministers seek the help of economists
during the formulation of economic policies.
1.1 Branches of Economics

By scope of Economics, we mean coverage or major areas of study. Economics when developed in
to a discipline, Comprises two main branches called microeconomics and macroeconomics.
A) Microeconomics
Microeconomics is a branch of economics that studies the economic decision making of firms and
individuals in a market. It is the study of the economy in the small. It is concerned with the economic
activities of individual consumers and producers or group of consumers and producers. In other
words, it is concerned with the specific economic units and a detailed consideration of the behavior
of these individual units.
In Microeconomics, we talk in terms of individual industry, firm, or household and concentrate up
on the functioning of individual industries and the behavior of individual decision-making units, i.e.,
single firm (business) and household. Microeconomics is useful in achieving a worm’s eye view of
some of the very specific components of an economy. Microeconomics examines individual trees in
a forest.

E.g. looks at the interactions of producers and consumers in individual marketssay, the
market for shoesand the interactions between different marketssay, the market for coffee
and the market for tea.

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 B) Macroeconomics
Macroeconomics is the branch of economics that studies the economy at large or the economy as a
whole. It is also the concern of macroeconomics to deal with the sub-aggregates (sub-divisions) of
the economy such as the government, total households in the economy, the whole industry, and
business sector, which make up the economy.
In dealing with aggregates, macroeconomics deals with obtaining general outline or overview of an
economy. In macroeconomics no attention is given to the specific units, which make up the various
aggregates, only the aggregates are a matter of concern.
Macroeconomics entails discussion on such magnitudes as national aggregates like national income
and output, saving and investment, total employment, general price level, etc. It considers the overall
performance of the economy with regard to the above variables and hence it is sometimes called
aggregate economics.

Macroeconomics studies also the behavior of economy-wide measures such as the Gross
National Productthe value of final output that the economy produces in a given time
periodas well as categories that cut across many markets, such as total employment in
manufacturing industries or total exports.

In both microeconomics and macroeconomics, the most important tools are the ideas of
demand and supply. They help explain price and output in individual markets and how
prices and output in different markets are related.

Did you understand the difference between microeconomics and macroeconomics?!

Microeconomics actually deals with the aspects like individual demand, individual supply,
individual income, individual employment, individual savings, and individual investment.
Macro-economics, on the other hand, is a study of broad economic events that are largely
beyond the control of individual decision makers and yet affect nearly all firms, households
and other institutions in the economy.

1.2. Methods of economic analysis

In order to solve the basic economic problems (What, how and for whom to produce)
economists design policies based up on principles or theories .This principles or theories
can be derived from facts.
Economic theories/analysis are drawn from facts through induction (from particular to
general) and deduction (from general to particular) methods.

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1.2.1Theories and Economic Models

Like other sciences economics is concerned with the explanation and prediction of observes
phenomenon.
Explanation and prediction of phenomenon is based on the use of theories.
Theory:A theory is developed to explain observed phenomenon based on a set of basic rules
and assumptions.It is a framework that helps us to understand the relationship between cause
and effect. It is simplification of an actual relationship and a hypothesis that has been
successfully tested .It can be true in general or on average and is often subject to exceptions
because of individual differences. For example, according to the theory of demand, other
things remaining constant, when price of a product increases, the quantity demanded of the
product will decrease. This is generally true. However, there may be some exceptional
individuals who may not like to buy cheaper products and decide to stop buying any
quantity of a product when its price decreases.

As we have discussed above, the objective of a theory is to predict and explain the cause of
phenomena we observe. Thus, it simplifies, generalizes, predict and explain the event. For
instance, the theory of demand helps us to predict by how much the quantity demanded of a
product will increase if its price falls by a certain amount and explains the reasons for such
negative relationship.
Using application of statistical tools and econometric techniques, we can construct models
from economic theories.
Economic Models: It is a skeletal and rough representation of the actual economy. In other
words, it is a simplified representation of the real situation that is achieved by a set of
meaningful and consistent assumption. A model can be represented by using graphs,
mathematical equations, computer programs etc.
We use models in order to simplify our complex real world and to minimize the costs we
incur while obtaining information. We evaluate models based on its assumptions,
generality, simplicity and how well it predicts its phenomenon.

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 1.2.1.1. Positive and Normative Economics
A. Positive Economics

Positive economics is deals with factual statements (“what is”) it focuses on how the economic
system works. Here we are concerned with observing the world as it is. It attempts to describe and
analysis the existing situation rather than suggesting how to change it. It seeks to explain and predict
the economic phenomena. For example we may be interested in increasing the revenue of the federal
government and the production of alcohol may be encouraged. The positive economists will not be
serially bothered whether the production of intoxicants will be detrimental to the interest of the
people or not. They are merely interested in seeking the way and means which the total revenue can
be increased. Generally it deals with internal benefit (profit) and cost of the economic activity of a
given firm on itself.
e.g.
 The current inflation rate in Ethiopia is 12 percent.
 Poverty and unemployment are the biggest problems in Ethiopia.
 The life expectancy at birth in Ethiopia is rising
B. Normative Economics

Normative economics involves value judgment (“ought to be”), this also known as “welfare
economics”. It is concerned what ought to be rather than with actually is. It provides economic
policy. It is based on your value judgments about what is good and what is bad. Hence, it is mixed
up with philosophical, cultural and religious positions. The welfare economists more plead for
prohibition of ethical grounds even though the federal government may be losing revenue. The
important task of normative economists is to define an ideal economy, an economy that can give
maximum satisfaction to individuals from the available resource. For example conceder alcohols
factory, the positive economics bothered how to maximize the revenue of the factory while the
normative (welfare) economics bothered about the intoxicant effect of the factory on the society.
Generally, it deals with external benefits (profits) and cost of economic activity of firms on the
society.
e.g. The poor should pay no taxes.

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1.3. Major Economic Problems
As we discussed above many of our economic problems are raised due to scarce resources
and unlimited human wants. This scarcity of resources created three major problems that
every society faces. These economic problems are what, how and for whom to produce.

What to produce: It refers to those goods and services and the quantity of each that the
economy should produce. Since resources are scarce or limited, an economy cannot produce
as much of every good and service as desired by all members of society. For this reason,
more of one good or service means less of others. Therefore, every society must choose
exactly which goods and services to produce and in what quantities. In other words, what to
produce refers to the problem of allocation of scarce resource between their alternative uses.

How to produce: It refers to the choice of the combination of factors and the particular
technique to use in producing a good or service. Different techniques of production can be
used to produce goods and services. Even if resources are generally scarce, some resources
may be relatively abundant than others in a country. For instance, in Ethiopia labor is
relatively abundant than capital. If the country uses more of labor and less of capital it
minimizes cost of production.
For whom to produce: This question refers to how the total output produced is to be
divided among different consumers. In every economy, due to scarcity no nation is capable
of satisfying all the needs of its society. As a result, the nation has to choose how to
distribute the output. For example, in market economy the distribution of goods and services
depends on the distribution of money income. That means, those who have more income can
enjoy more of the goods and services and those who have less income can enjoy less of the
goods and services.
1.3.1. Economic system

Do you know the different economic systems prevailing in the world? Can you answer the
above basic economic questions from the point of view of these systems? Anyway,
economists divide economic systems into four major groupsthe traditional economy, the
planned (command) economy, the market economy, and the mixed economy. Just read
attentively so as to understand how the basic questions are answered in these four systems.

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1) The Traditional Economy: The traditional economyanswers the fundamental
microeconomic questions by appeal to tradition. What is produced is what the young have
been taught by their parents to hunt, to gather, or to plant. The techniques of production of
how to produce are also passed on, often without change, from generation to generation. The
amount of production is, of course, highly dependent on good fortune. The last question,
concerning distribution, is also traditionally determined. In fact, traditional societies may
have rules on how output is to be divided.

2) The Planned Economy:It answers the fundamental microeconomic questions through

planning or through central command and control. The decisions regarding what, how, and
how much to produce are spelled out and documented. Detailed plans and orders are sent to
producers, and these instructions carry the weight of the law. A large part of the question of
who gets what is determined in the same way, because planners determine wage rates and
the amount of production of consumer goods. Of course, in any economy, people plan; that
is, they think about the future and make preparations for it. Economists use the term planned
economy to refer to one in which the government plays a large role in answering the
production and consumption questions of the society.

3) The Market Economy:The organizing principles, here, are the forces of demand and
supply. The determination of what to produce is made by consumers, and the force of
demand causes prices to go up for certain products when consumers desire more of them.

In a sense, consumers vote with their money. The result of this voting process determines
what will be produced. Suppliers combine resources, determining how things are to be
produced. Assuming suppliers are self-interested and seek to maximize their profits, they
tend to combine inputs to produce any good or service at the lowest possible cost. This
determination depends on the prices of resources. Suppliers will use more of relatively
abundant resources because they are relatively cheap. This, in turn, helps conserve the
scarcer (more expensive) resources. The goods are then distributed to consumers who have
the purchasing power to buy them. Those who have more purchasing power receive more
goods and services.

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4) The Mixed Economic System: In the real world we find that economies are the blend of
traditional, planned and market economic systems. In practice every economy is a mixed
economy in the sense that it combines significant elements of all three systems.

Furthermore, within any economy, the degree of the mix will vary from sector to sector. For
example, in some planned economies the command principle was used more often to
determine behavior in heavy goods industries, such as steel, than in agriculture. Farmers
were often given substantial freedom to produce to varying market prices.

When we speak of a particular economy as being a centrally planned economy, we mean

only that the degree of the mix is weighted heavily toward the command principle. When we
speak of an economy as being a market economy, we mean only that the degree of the mix is
weighted heavily toward decentralized decision making in response to market signals. It is
important to realize that such distinctions are always matters of degree, and that almost
every conceivable mix can be found across the world’s economies.

1.4. Scarcity, choice and Opportunity Cost

1. Scarcity
The fundamental economic problem that any human society faces is the problem of scarcity.
Scarcity refers to the fact that all economic resources that a society needs to produce goods
and services are finite or limited in supply. But their being limited should be expressed in
relation to human wants. Thus, the term scarcity reflects the imbalance between our wants
and the means to satisfy those wants.
Free resources: A resource is said to be free if the amount available to a society is greater
than the amount people desire at zero price. E.g. sunshine
Scarce (economic) resources: A resource is said to be scarce or economic resource when the
amount available to a society is less than what people want to have at zero price.
The following are examples of scarce resources.
 All types of human resources: manual, intellectual, skilled and specialized labor;
 Most natural resources like land (especially, fertile land), minerals, clean water, and
forests and wild – animals.
 All types of capital resources ( like machines, intermediate goods, infrastructure );
and

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  All types of entrepreneurial resources.

Economic resources are usually classified into four categories.

 Labour: refers to the physical as well as mental efforts of human beings in
theProduction and distribution of goods and services. The reward for labour is called
wage.
 Land: refers to the natural resources or all the free gifts of nature usable in
theProduction of goods and services. The reward for the services of land is known as
rent.
 Capital: refers to all the manufactured inputs that can be used to produce other
goods and services. Example: equipment, machinery, transport and communication
facilities,etc. The reward for the services of capital is called interest.
 Entrepreneurship: refers to a special type of human talent that helps to organize
and

Manage other factors of production to produce goods and services and takes risk of Making
loses. The reward for entrepreneurship is called profit.
Entrepreneurs are individuals who:
 Organize factors of production to produce goods and services.
 Make basic business policy decisions.
 Introduce new inventions and technologies into business practice.
 Look for new business opportunities.
 Take risks of making losses.

Note: Scarcity does not mean shortage. We have already said that a good is said to be scarce
if the amount available is less than the amount people wish to have at zero price. But we say
that there is shortage of goods and services when people are unable to get the amount they
want at the prevailing or on going price. Shortage is a specific and short term problem but
scarcity is a universal and everlasting problem.
2. Choice
If resources are scarce, then output will be limited. If output is limited, then we cannot
satisfy all of our wants. Thus, choice must be made. Due to the problem of scarcity,

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individuals, firms and government are forced to choose as to what output to produce, in what
quantity, and whatoutput not to produce.
In short, scarcity implies choice. Choice, in turn, implies cost. That Means whenever choice
is made, an alternative opportunity is sacrificed. This cost is known as opportunity cost.
Scarcity → limited resource → limited output → we might not satisfy all our wants
→choice involves costs → opportunity cost
3. Opportunity cost
In a world of scarcity, a decision to have more of one thing, at the same time, means a
decision to have less of another thing. The value of the next best alternative that must be
sacrificed is, therefore, the opportunity cost of the decision.

Definition: Opportunity cost is the amount or value of the next best alternative that must be
Sacrificed (forgone) in order to obtain one more unit of a product.
For example, suppose the country spends all of its limited resources on the production of
cloth or computer. If a given amount of resources can produce either one meter of cloth or
20 units of computer, then the cost of one meter of cloth is the 20 units of computer that
must be sacrificed in order to produce a meter of cloth.
When we say opportunity cost, we mean that:
It is measured in goods & services but not in money costs
It should be in line with the principle of substitution.
In conclusion, when opportunity cost of an activity increases people substitute other
activities in its place.

1.4.1. Production Possibilities

Let us classify factors of production discussed earlier. In their production process, firms use
factors of production. These factors of production are often divided into four categories:
entrepreneurship, labor, land, and capital.

Let us discuss about production possibilities. To see the production possibilities open to a
firm (or any production unit), consider the choice between the production of food and
clothing. It is possible to increase the production of both only if there are some unused
resources. That is, if there is some unemployed labor, unused land, idle capital etc., the

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production of both food and clothing could be increased. But if factors of production are
fully employed, it is not possible to have more of both.

Assuming that factors of production are fully employed, there are only two goods, food and
clothing, and factors of production are homogenous; the production possibility open to a
production unit can be presented using the production possibility curve (PPC).

The assumption of homogenous factors of production implies that all units of labor, capital
and land are identical. This assumption, in fact, contrasts with reality. Do you think that the
productivity of two pieces of land, one in a highland area and one in a desert, can be the
same? Definitely no.

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Food

10 a
8 b Production Possibility Curve
4 c

0 7 10 Clothing
Figure 1.1: Production Possibility Curve

There are three important regions in Figure 1.1 above. Can you identify them? If yes, good.
If no, don’t worry. We will see it together. If resources are fully employed, the firm will be
able to produce combinations of food and clothing on the PPC such as point a. If there are
some unused resources (if there is underutilization) the firm will produce combinations to
the left of the PPC such points like b. Production above the PPC at points like c is
impossible for any given quantity of factors of production, and therefore is called
unattainable region. For any given quantity of factors of production, the attainable region of
production is that on and below the PPC.

The production possibility curve illustrates three concepts: scarcity, choice, and opportunity
cost. Scarcity is indicated by the unattainable combinations above the PPC; choice, by the
need to choose among the alternative attainable points along the PPC; and opportunity cost,
by the negative slope of the PPC.

Suggested Reading Materials

Lipsey R. G., Courant P. N., PurvisD.D., and Steiner P. O., Microeconomics, 10th ed. New
York: Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-
Western Publishing Co., 1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

UNIT TWO

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 THEORY OF DEMAND AND SUPPLY

1. Theory of Demand

Objectives

At the end of this section, you will be able to:

 Define demand and list the factors that influence it;

 Demonstrate the concept of demand using words, numbers or functions, and graphs;

 Identify on a graph the differences between changes in demand and changes in

quantity demanded; and

 Show how changes in ceteris paribus conditions affect demand.

2.1.1. Definitions

Demand: - refers to the desire and ability to consume certain quantities at certain prices.

Demand schedule: a tabular listing that shows the quantity demanded at various prices,
ceteris paribus. The phrase ceteris paribus means other things remain the same. The
importance of this assumption will be clear from the discussions in subsequent sections.

So as to derive the demand schedule of an individual (say Mr. Abebe) what is required is
just asking him what quantity of the good (say bread) he would buy at different prices of the
good, ceteris paribus. Look at the following table for illustration.

Table 2.1: Demand schedule

P r i c e Quantity
0 2 5 0
5 2 0 0
1 0 1 5 0
1 5 1 0 0
2 0 5 0
2 5 0

Demand curve: - a graphical representation of a demand schedule showing the quantity

demanded at various prices, ceteris paribus. Plotting the price-quantity relationships from

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the demand schedule on a two-axis plane derives the demand curve for a good or service
given in figure 2.1 below.

Price
25
20 Demand curve
15
10
5

0 50 100 150 200 250 Quantity

Figure 2.1: The Demand Curve

2.2. Determinants of demand

Demand for goods and services is affected by several factors. These factors include

1. The price of the goods and services.

2. The tastes of the group demanding the good.

3. The size of the group (population size).

4. The income and wealth of the group.

5. The prices of other related goods and services.

6. Expectations about future prices or income.

7. Others (such as religion, weather, …)

Demand is, therefore, a multivariate function:

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 Qd = f (P, Po T, S, I, E, Z)

Where: P is output price

Pois the price of other goods and services.

T is the taste of consumers toward the good.

S is the size of the population in the market.

I is the income of consumers.

E is the expectation of consumers about future market conditions.

Z is other factors.

All things that affect demand work through one of these factors. When studying demand all
factors that affect demand, except one, are kept constant (ceteris paribus) and we determine
what happens to demand when the factor under consideration changes.

2.1.2. The Law of Demand

Can you think of the relationship between price and quantity demanded for a given product?
Good. Now, let us discuss the law of demand in order to understand it.

The law of demand states that the quantity demanded of a good or service is negatively
related to its price, ceteris paribus. Holding other things the same, consumers will buy more
of a good or service at a lower price than at a higher price. As price rises, consumers will
demand a smaller quantity of a good or service.

At this point, it is important to make distinction between demand and quantity demanded of
a good or service. Demand refers to the whole set of price-quantity combinations, i.e.,
demand defines the whole set of relationship between price and quantity. Quantity
demanded, on the other hand, is the amount consumers want to buy at a particular price, i.e.,
the quantity of a good or service that consumers demand at price Birr 1, the quantity they
demand at price Birr 2 etc.

2.1.3. Individuals’ Demand for a Product

Think of your own demand for a given product and compare it with following concept. An
individual’s demand for a product is the quantity of the good that the consumer would buy at

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various prices. Suppose we ask individual A how many units of a good he/she would buy at
alternative prices. The individual’s response would reflect his/her demand for the good. If
the different price-quantity combinations are plotted on a two-axis plane, the result would be
the individual’s demand curve.

For instance, the demand schedule above could show individual A’s demand for the good
under consideration at different prices. Plotting the individual demand schedule on a two-
axis plane yields the demand curve of the individual. (See Table 2.1).

2.1.4. Market demand

The market demand for a given product is obtained by horizontal summation of individual
demands of all consumers for that particular good. Suppose there are just two individuals (A
and B) in a market. In this particular case, the market demand for the product is simply the
horizontal summation of the quantities the two individuals buy at alternative prices.
Consider the demand schedules of the two individuals indicated in the following table:-

Table 2.2: Individual Demand Schedules

Demand schedule of A P r i c e 0 1 2 3 4 5
Quantity 5 0 4 0 3 0 2 0 1 0 0
Demand schedule of B P r i c e 0 1 2 3 4 5
Quantity 3 0 2 0 2 5 2 0 1 5 1 0

Can you derive market demand based on the above individuals demand? Good. It is as
simple as the following. The market demand schedule is obtained from the horizontal
summation of the quantity demanded by individuals A and B at different prices.

Table 2.3: Market Demand Schedule.

Price 0 1 2 3 4 5
Quantity 8 0 6 0 5 5 4 0 2 5 1 0

At price 0, A is willing to buy 50 units of the product, while B is willing to buy 30 units.
Therefore, the market quantity demanded at price 0 is 80 (30 + 50 = 80). Similarly, the
market quantity demanded at price 1 is 60: the sum of A’s demand (40 units) and B’s
demand (20 units). As price rises the quantity demanded in the market decreases. This
conforms to the law of demand.

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The market demand curves are similarly obtained from simple horizontal summation of
individual demand curves as given below:-

Price
6
5 Market demand curve
4
3
2
1

0 10 25 40 55 60 80 Quantity
Figure 2.2: Market Demand Curve

2.1.5. Demand Function

Can you indicate the functional relationship between price and quantity using the concept
discussed under the theory of demand? Ok. Let us continue.

Demand function shows the functional relationship between the quantity demanded of a
good and its price, ceterisparibus. It is defined as:

Q= f(P)

The demand function gives quantity demanded as a negative function of price. The most
widely used functional form is a linear demand curve, which is given as:

Q a  bP

What do you think is the slope of this demand function? Ok. It is –b.

In a more general case, in which the market consists of n consumers with individual demand
functions for goods X is defined as:-

Xi = f (PX)

where Xi represents the quantity demanded of good X by individual i.

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The market demand for good X (Xm) is given as:
n
X m  X i
i 1

The market demand curve (see Figure 2.2), therefore, could be considered to show the
relationship between market demand (Xm) and price PX , other things remaining constant.

2.1.6. Movement along the Demand Curve and Shift in the Demand Curve

Let us look at the effects of the different determinants of demand on demand curve.

As stated above demand is a multivariate function. Changes in the determinants of demand

cause changes in demand. These changes in demand which result from changes in its
determinants can be classified into movement along the demand curve and shift of the
demand curve.

Movement along the Demand Curve

Think of the determinants of demand we discussed earlier. Which of these determinants do

you think is responsible for movement along the demand curve? We will see it together. Just
follow attentively:-

Movement along the demand curve refers to that change in the quantity demanded of a good
because of changes in the prices of that good while other factors affecting demand (such as
price of other goods, income etc.) remaining the same (unchanged).

The consumer buys larger quantities at lower prices and lower quantities at higher prices.
Therefore, such movements take the consumer from one point on the demand curve to
another point on the same demand curve. In Figure 2.3 below, reduction of price from P1 to
P2 increases quantity demanded from Q1to Q2.

This represents what is called change in quantity demanded.

P D
P1 a

P2 b

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 D

0 Q1 Q2 Q
Figure 2.3: Movement along the Demand Curve

Example 2.1

Suppose a demand function for a theater ticket is given as Q 100  2 P . If now price
changes from Birr 2 to Birr 2.50, its effect will be a decline in quantity demanded from 96
tickets to 95 tickets. On a demand curve this can be shown by a movement from coordinate
(2, 96) to coordinate (2.50, 95).

2.1.6.2. Shift in the demand curve

Let us consider the second change: shift in demand curve. The demand curve is drawn on
the assumption that other things remain the same. If, however, the factors assumed constant
change, their effect would be shifting the demand curve. In other words, shift in the demand
curve for a good result from changes in one or more of the factors that affect demand except
the price of own good. Increase in demand is shown by outward shift of the demand curve
whereas inward shift of the demand curve represents decrease in demand.

When the tastes of the people change in favor of bread, it would be reflected by an increase
in demand for bread. At every price, consumers demand a larger amount than before. This,
as shown in Figure 2.4, shifts the demand curve from D to D1. The opposite would have
occurred if tastes change against bread, in which case there would be decrease in demand,
represented by a shift from D to D2. Look at the following figure for illustration.

P1

D D1

20
 D2
0 Q2 Q Q1 Q
Figure 2.4: Shift of the Demand Curve

An increase in the size of the population has an effect of shifting the demand curve from D
to D1. Suppose the government reduces the minimum driving age from 18 to17. Following
this reduction, the population of driving age increases. This, in turn, will have the effect of
increasing the demand for cars. Decrease in the size of population, on the other hand, shifts
the demand curve from D to D2. This would be the case if the minimum driving age were,
for example, raised to 20.

What do you think is the effect of an increase in income of consumers on quantity

demanded? The answer may not be simple. Please read carefully. An increase in income
leads to an increase or a decrease in demand depending on the nature of the good.
Depending on the effect of change in income on their quantity demanded, there are two
types of goods: normal goods and inferior goods. Demand increases with increase in income
if the good is normal. As an example, consider meat whose demand is directly related with
income. On the other hand, inferior good is a good whose demand decreases with increase in
income. If, for example, you decrease your consumption of ‘shiro wet’ as your income
increases in order to shift to say meat, then ‘shiro wet’ is going to an inferior good for you.

The price of related goods and services also has effect on demand depending on the nature
of the other goods. There are two classes of such goods:

Substitute goods- such goods are substitute to one another. As a result, an increase in
the price of such related goods leads to increase in demand for the other good. Consider
Pepsi Cola and Coca Cola. If the price of Coca Cola increases consumers will shift from
the consumption of Coca Cola to Pepsi Cola. This implies increase in the price of Coca
Cola results in the increase of the demand for Pepsi Cola.

Complementary goods- these are goods that are jointly consumed. As a result, a rise in
the price of one such good results in decline in demand of the other good. Consider the
case of sugar and coffee. Coffee is consumed together with sugar. Thus, increase in the
price of sugar causes decline in demand for coffee. The converse is true for decrease in
the price of sugar.

21
 Can you explain the effect of future expectations on demand curve? Anyhow,
expectations also have influence on demand. If individuals expect prices to change in the
future for any reason, they may take action that they otherwise might postpone. Suppose
consumers expect prices to fall in the future. In this case they reduce current
consumption hoping to buy more of the good when price falls in the future. If, on the
other hand, they expect prices to rise in the future, they will consume more of the goods
at present so as to avoid buying the good at a higher price in the future.

Similarly, change in expectation about the future income influences the decision of
consumers. If consumers expect their income to increase in the future, they would increase
their current consumption through current borrowing. On the other hand, if they expect
income to decrease in the future they will reduce current consumption.

2. Theory of Supply

Objectives
At the end of this section, you will be able to:

 Define supply and list the factors that affect it;

 Demonstrate the concept of supply using words, numbers or functions, and graphs;

 Identify on a graph the differences between changes in supply and changes in

quantity supplied; and

 Show how changes in ceteris paribus conditions affect supply.

2.2.1. Definitions

Supply refers to the quantity of goods offered for sale at a particular time or a particular
place at alternative prices.

Supply defines the whole set of price-quantity relationship. It shows the quantities that
producers are willing and able to supply at alternative prices, ceteris paribus. It is different
from quantity supplied, which represents the actual quantity that producers supply at each
price.

Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris
paribus. Look at the table below.

22
Table 2.4: Supply Schedule

Price 5 1 0 1 5 2 0 2 5
Quantity 1 0 2 0 3 0 4 0 5 0

Supply curve: is a graphical representation of a supply schedule showing the quantity

supplied at various prices, ceteris paribus (see Figure 2.5 below).

P
25 Supply curve
20
15
10
5

0 10 20 30 40 Q
Figure 2.5: Supply Curve

Determinants of supply

The supply of goods or services is affected by several factors. The factors that influence
supply include:

1. The price of the good (P).

2. The level of technology (T).

3. The price of factors of production (Pf).

4. The number of suppliers (S).

5. Expectations (E).

23
 6. Others (Z)

Everything that affects supply works through one of these determinants. Supply function is,
then, defined as

Qs = f (P, T, Pf, S, E, Z)

2.2.2. The Law of Supply

The supply curve shows the relationship between the quantity supplied of a good and its
price. Therefore, in order to see what happens when the price of the good under
considerations changes, everything but the price of the good must be held constant. Given
these conditions, the law of supply states that the quantity supplied of a good or service is
usually a positive function of price, ceteris paribus.

However, this positive relationship between price and quantity supplied fails in two
exceptional cases:

 The supply will not be upward sloping if there is no enough time to produce more
units of the good because production techniques are not flexible in the very short run.
Suppose a given firm is operating at full capacity in the short run. Under such
circumstances, the firm will not be able to positively respond to increase in price of
any magnitude. The law is not applicable in the immediate short-run.

 When a unique supplier no longer exists, quantity supplied will not exhibit positive
relationship with price. In such cases, though prices rise to very high levels, the
producers no longer exist to supply more of the products. Consider, as an example,
the paintings of a famous painter such as Picasso.

In these unusual cases, quantity supplied does not respond to price at all. Accordingly the
supply curve will be horizontal parallel to the quantity axis.

24
2.2.3. Individual Firm’s Supply

An individual firm’s supply shows the different quantities that the firm would supply at
various prices. So as to derive an individual firm’s supply schedule, just ask the firm the
quantities it would supply at alternative prices, and if it is able to state, then the different
price-quantity supplied combinations define the individual firm’s supply.

The supply schedule above could be considered to represent an individual firm’s supply
schedule. Plotting these combinations on a two axis plane gives the individual firm’s supply
curve, which is upward sloping under normal circumstances.

2.2.4. Market (Industry) Supply

Can you derive market supply from individuals supply as we did for market demand? Good.
We can use similar as follows. The market supply curve is obtained by horizontal
summation of the individual (firm) supply curves. This curve represents the sum of the
quantities supplied by each firm at different prices. If there are just two firms in the market,
for example, the market supply schedule can be derived from the simple horizontal
summation of the quantity supplied by the two firms at each price.

Table 2.5: Individual Supply Schedules

Supply schedule of firm 1 P r i c e 0 1 2 3 4

Q ua n tit y 0 1 0 2 0 3 0 4 0
Supply schedule of firm 2 P r i c e 0 1 2 3 4
Q ua n tit y 0 1 5 3 0 4 5 6 0

Table 2.6: Market Supply Schedule

Price 0 1 2 3 4
Quantity 0 2 5 5 0 7 5 1 0 0

25
Suppose in the above example, firm 1 has a larger market share and firm 2 has a relatively
lower market share. Accordingly, firm 1 has larger supply curve while firm 2 has a lower
supply curve. In this case, the industry (market) supply curve is given in Figure2.6 below.

P S2 S1

(S1+S2)=market supply

P2
P1

0 Y
Figure 2.6: Market Supply Curve

The market supply is the horizontal summation of individual supply curves. For price level
less than P2 firm 2 supplies no output at all. As a result the market supply curve coincides
with firm 1’s supply curve. For price level less than P1 since firm 1’s level of output is zero,
market supply will also be zero. Such market supply curve is a graphical depiction of how
much will be offered for sale in the market at various prices.

In a more general case with n number of firms in the industry (market), the market supply
function S(p) is given as:
n
S ( p )  S i ( p )
i 1

whereSi is the supply function of individual firms.

2.2.5. Supply Function

Now, we can explain supply function as we did for demand. Supply function shows the
functional relationship between price and quantity supplied, ceteris paribus. And it is
generally defined as:

Q = f (P)

The most widely used functional form is the linear supply curve, which is given as:

26
 Q c  dP

The slope of the supply function is d.

2.2.6. Movement along the Supply Curve and Shifts in the Supply Curve

As is stated above supply decision by an individual firm is affected by several factors.

Change in the factor determining supply cause either movement along the supply curve or
shift of the supply curve.

2.2.6.1. Movement along the Supply Curve

Movement along any supply curve occurs because of changes of the price of the good or
service under study while holding other factors constant. These changes in quantity supplied
result as a positive function of changes in price. Because producers are willing to sell more
units if the price rises to cover the additional costs of production, we observe movement
along the same curve.

Graphically, the effect of change in the price of the product concerned is shown by
movement from one point on the supply curve to another point on the same curve. In the
figure below fall in price from P1 to P2 leads to increase in quantity supplied from Q1 to Q2.

Price
Supply
P1 b

P2 a

0 Q1 Q2 Quantity

Figure 2.7 Movement along the supply curve

27
Example 2.2

Suppose the supply function of a grocery is given as Q  20  5 P . The effect of rise in

price from Birr 6 to Birr 7 would be rise of quantity supplied from Birr 10 to Birr 15. On a
supply curve, this would be shown by movement from coordinate (6, 10) to coordinate (7,
15).

2.2.6.2. Shifts in the Supply Curve

Shifts in the supply curve occur as any one of the ceteris paribus factors (factors kept
constant earlier) is altered. These constitute what is called change in supply (not change in
quantity supplied). Change in quantity demanded results from change in the price of the
good with other things remaining the same.

Suppose technology changes, and this change has a positive effect. For instance, assume we
are looking at the supply of beef and that agricultural researchers develop a very inexpensive
pill that causes a young steer to double in weight rapidly. This technological advance means
that more beef will be supplied at each price. There will be increase in supply. Such an
increase in supply is represented by a rightward shift of the supply curve. In the figure below
such effects are shown by shift of the supply curve from S to S1 (see Figure 2.8).

A negative technological change will have the opposite effect. Suppose the government
discovers that this drug, now in use for steer fattening, has harmful side effects on humans
and farmers are, therefore, prohibited from giving it to steers. This will mean that less beef
will be supplied at each price. There will be a decrease in supply, which is depicted as a
leftward shift of the supply curve. This is shown by shift of the supply curve from S to S2
(see Figure 2.8).

P
S2 S
S1
P2
P1

28
0 Q2 Q1 Q
Figure 2.8 Shift of the supply curve

Now consider changes in the prices of factors of production. A rise in the price of a factor of
production, ceteris paribus, causes a decrease in supply. This happens because the producer
now will find that the cost of supplying any quantity has increased. We will, thus, find that
after a price rise in the price of a factor of production, less will be supplied at the old price or
the same amount will be supplied only at a higher price. This is graphically represented by a
shift in the curve from S to S2. The opposite is also true: any decrease in the price of a factor
of production will cause an increase in supply.

A change in the number of suppliers similarly will have a predictable effect on supply. For
instance, if the number of beef ranchers declines, the total supply of beef at each price will
be reduced. Thus, the supply curve will shift to the left from S to S2. Conversely, an increase
in the number of ranchers will cause increase in total supply of beef, and hence, the supply
curve to shift to the right from S to S1.

As in the case of demand, expectations about any of the ceteris paribus conditions or about
price can have an effect on supply. Assume that ranchers expect that the price of beef will
fall next year because they anticipate a poor harvest, which would make it more expensive
to keep beef on feedlots. Under such expectations, they would bring more cattle to market
now before price falls. If enough farmers follow suit, the supply for this year will increase as
shown in the figure above, by a rightward shift of the supply curve.

3. Market Equilibrium

In the earlier two sections, we have independently seen about the theory of demand and the
theory of supply. In this section, however, we will bring the two theories together and
discuss their interaction in determining market price and quantity.

In a free market system output price as well as the level of output in a market are determined
by the forces of demand and supply. The condition of equality of demand and supply is
called equilibrium. In this section we will consider the derivation of the equilibrium

29
condition. The equilibrium condition is affected by changes in the factors that affect
demand and supply. Due attention, accordingly, will be given to see the effects of such
changes on equilibrium.

Objectives:

At the end of this section, you must be able to:

 Define equilibrium;

 Explain how equilibrium is reached; and

 Show how changes in demand and supply affect the equilibrium condition.

2.3.1. Definition

Market equilibrium is a price-quantity combination that results from the interaction of the
supply curve and the demand curve such that at the indicated price, the quantity demanded
equals the quantity supplied.

The equilibrium has the property that once the market settles on that point it stays there
unless either supply or demand shifts. Additionally, a market that is not at the equilibrium
position moves toward that point. These two points can be made clear by considering the
graphic representation of equilibrium discussed below.

2.3.2. Graphic Approach to Equilibrium

Let us see the determination of equilibrium using graphic approach. To see how equilibrium
comes about, consider the following hypothetical demand and supply of coffee in a given
market given by Table 2.7 and its corresponding figure (Figure 2.9).

At a price of Birr 2.00, suppliers want to supply 4 thousand kg of coffee and demanders
want to purchase 8 thousand kg. The quantity demanded exceeds quantity supplied by
4 thousand kg. This means that some consumers do not get the desired amount at price Birr
2.00. Some of these consumers will offer more and bid the price up. As the price rises, the
quantity supplied, being a positive function of price will rise and the quantity demanded,
being a negative function of price, will fall. This will continue until the price reaches Birr
3.00. At Birr 3.00, the amount consumers wish to purchase is exactly equal to the amount

30
suppliers wish to sell. This is the equilibrium price (market clearing price). The output
which corresponds to the equilibrium price is called the equilibrium quantity.

Table 2.7: Supply of and Demand for Coffee

Price per Kg Kg supplied per month Kg demanded per month D i f f e r e n c e

B r 1 . 0 0 2 thousand 10 thousand 8 thousand excess quantity demanded
B r 2 . 0 0 4 thousand 8 thousand 4 thousand excess quantity demanded
B r 3 . 0 0 6 thousand 6 thousand Equilibrium (no excess )
B r 4 . 0 0 8 thousand 4 thousand 4 thousand excess quantity supplied
B r 5 . 0 0 10 thousand 2 thousand 8 thousand excess quantity supplied

Price/kg

5.00 4 thousand excess supply S

4.00
3.00
2.00
1.004 thousand excess demandD
0 1 2 3 4 5 6 7 8 9 10 Thousand Kg
Figure 2.9 Market Equilibrium
It is important to note that the point representing equilibrium price and equilibrium quantity
is not the same thing as the point where the amount sold equals the amount bought.
Quantities bought and quantities sold are always equal. But at equilibrium the quantity that
suppliers wish to sell is exactly equal to the quantity demanders wish to purchase, i.e., the
equilibrium represents coincidence of wishes on the part of consumers and producers.

 Excess demand causes an upward pressure on price. Thus price converges to the
equilibrium price.

 Excess supply causes a downward pressure on price. Thus, price follows a path
towards the equilibrium.

Once equilibrium is reached at the point of equality of the demand curve with the supply
curve, it remains there as long as demand and supply remain unchanged.

31
2.3.3. Numerical Approach to Equilibrium

Dear learner,did you understand how equilibrium levels of price and quantity can be
determined? Ok. Let us proceed with the same analysis but using numerical approach.

At the equilibrium position, the demand function is exactly equal to the supply function.

Q c  dP
If demand is given as Qd  a  bP and supply is given as s , the equilibrium
condition is

Supply = Demand

a  bP c  dP

Rearranging gives:

bP  dP a  c

P (b  d ) a  c

The equilibrium price is, therefore:

a c
P
bd

The equilibrium quantity is obtained by substituting the equilibrium price into the demand or
supply function.

a c
P
Substituting b  d in the demand function Q a  bP

a c
Q a  b( )
b  d or,

a c
P
Substituting b  d in the supply function Q c  dP

a c
Q c  d ( )
bd ,

a c a c
a  b( ) c  d( )
Where bd = bd .

32
Example 2.3

Suppose the demand and supply functions in a particular market are given as:

Qd 100  2 P

Qs 10  4 P

At equilibrium Qd = Qs

100  2 P 10  4 P

Rearranging

6 P 90

The equilibrium Price is, therefore, P = 15.

The equilibrium quantity is obtained by substitution.

Qd 100  2(15) 70 Qs

Exercise 2.3
?
Qd 50  3P
P1 Given and Qs 15  2 P , find equilibrium levels of price and quantity.

2.3.4. Effects of Change in Demand

Do you remember the ceteris paribus conditions? Good. Now, we are going to see the effect
of these conditions. When the ceteris paribus conditions (price of other goods, consumers’
income, taste, population size, expectation etc.) change, there will be a shift in the demand
curve. Such changes (shifts) in demand result in a shift of the equilibrium position.

Assume first, there is increase in demand, for any one reason, represented by an upward
(rightward) shift in the demand curve. Such rise in demand, with supply constant, creates
shortage at the initial equilibrium price, and the unsatisfied buyers bid up the price. This
causes a larger quantity to be produced, with the result that at the new equilibrium more is
bought and sold at a higher price. This change, with supply remaining the same, shifts the
equilibrium position from e0 to e1. The equilibrium price rises from P0 to P1and equilibrium

33
quantity rises from Q0 to Q1. That means, consumers are now demanding larger quantities of
the good at every price than before (See the figure below).

P
S0
P1 e1
P0 e0
P2 e2 D1
D0
D2
0 Q2 Q0 Q1 Q
Figure 2.10 effects of change in demand

On the other hand, fall in demand, ceteris paribus, creates surplus, and the unsuccessful
sellers bid the price downwards to clear the surplus. As a result, less of the commodity is
produced and offered for sale. At the new equilibrium, both price and quantity bought and
sold are lower than they were originally.

Such fall in demand is represented by a leftward (downward) shift of the demand curve, and
causes the equilibrium position to shift from e0 to e2. Accordingly, equilibrium price falls
from P0 to P2 and equilibrium quantity falls from Q0 to Q2.

With regard to change in demand the equilibrium price and quantity change in the same
direction. The magnitude of the change in price and quantity demanded depends on:

 The size (magnitude) of demand change

 The slope (elasticity) of supply

For any given supply curve, the higher the size of change in demand the higher the change
in equilibrium price and quantity (See Figure 2.11 below). The size of change in demand is
high in panel (b) than in panel (a). Therefore, the changes in equilibrium price and quantity
are high in the former than in the later.

P SP S
P1 e1
P1 e1

34
 P0 e0 P0 e0
D1D1
D0D0
0 Q0 Q1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.11: Shifts in demand in Different Magnitudes

Example 2.4

With the supply function in example 2.3 remaining the same at Qs 10  4 P , suppose the
Qd 130  2 P
demand function changes to .

At equilibrium 130  2 P 10  4 P 6 P 120 P 20

Qd 130  2(20) 90 Qs

The effect of such rise in demand would be rise in price and quantity demanded.

Exercise 2.4
?
P1
The supply function of a firm is given as Qs 10  4 P . Compare the effects on
equilibrium price and quantity of change in demand

Q
a. From Qd 100  2 P to d
130  2 P .

b. From
Qd 100  2 P to Qd 160  2 P .

How do you explain the differences, if any?

For any given change in demand, the change in equilibrium price is higher and the change in
equilibrium quantity is lower the steeper the supply curve (the higher the slope of the supply
curve). The converse would be true if supply curve is flatter.

P S P
P1e1 S
P0 e0 P1 e1
P0 e0

35
D1
D0D0D1
0 Q0 Q1 Q 0 Q0 Q1 Q

(a) (b)

Figure 2.12: Effects of Difference in the Slope of Supply

In the figure above, the supply curve in (a) is much steeper than the supply curve in (b).
Accordingly, the resulting changes in equilibrium price and quantity for any given shift of
the demand curve are different.

Assume the changes in demand in the two cases are equal. As demand shifts from D0 to D1,
the changes inequilibrium price and quantity are given by (P1-P0) and (Q1-Q0) respectively.
Yet (P1-P0) is higher in (a) than in (b), and (Q1-Q0) is higher in (b) than in (a).

Example 2.5

Suppose the demand function has shifted from

Qd 100  2 P to Qd 130  2 P , consider

the change in the equilibrium price and quantity for supply functions
Qs 10  4 P and

Qs 10  P . Here the first supply function is flatter than the latter.

The initial equilibrium under the two supply functions

Case 1 Case 2

100  2 P 10  4 P 100  2 P 10  P

6 P 90 P 15 3P 90 P 30

Qd 100  2(15) 70 Qs Qd 100  2(30) 40 Qs

The new equilibrium after the shift in demand

Case 1 Case 2

130  2 P 10  4 P 130  2 P 10  P

6 P 120 3P 120

P 20 P  40

36
Qd 130  2(20) 90 Qs Qd 130  2(40) 50 Qs

Colleague, as the demand curve shifts, the change in equilibrium price is higher and the
change in equilibrium quantity is lower for the steeper supply curve than for the flatter one.

This implies, therefore, that for any given change in demand, change in price will be higher
and change in quantity lower the steeper the supply curve.

Exercise 2.5
?
P1 QdA 100  2 P
Suppose the demand functions of two markets, A and B are given as:

and
QdB 100  P . If the two markets have the same supply condition and the supply

functions shift from

Qs 10  4 P to Qs 40  4 P , compare the resulting changes in the two
markets.

2.3.5. Effects of Change in Supply

Dear colleague, can you explain the effect of change in supply? Ok. Let us discuss it
together. Shift in the supply curve resulting from changes in the ceteris paribus conditions,
causes shift of the equilibrium position (point). An increase in supply for one or the other
reason would shift the supply curve rightward from s0 to s1. With demand remaining the
same, this shift causes shift of the equilibrium point from e0 to e1. Accordingly, there will be
shifts in equilibrium price and quantity.

The effect of such shift in supply would be decline in equilibrium price because the increase
in supply exerts downward pressure on price, and increase in equilibrium quantity because
now that the total supply at each price is higher compared to the initial condition, producers
wish to sell off their products at lower prices.

Accordingly, the equilibrium price and quantity change from P0 to P1 and from Q0to Q1
respectively.

37
 P D S2 S0
S1
P2 e2
P0 e0
P1 e1

0 Q2 Q0 Q1 Q
Figure 2.13: Effects of Shift in Supply

If, on the other hand, supply decreases as given by the leftward shift of the supply curve
from S0 to S2, there will be consequent shift of the equilibrium point from e0 to e2. The effect
of such change in supply is increase in equilibrium price and fall in equilibrium quantity
because, with demand remaining the same, producers are willing to sell lower quantities at
each price. The equilibrium price and quantity change from P0 to P2 and from Q0 to Q2
respectively.

The magnitude (size) of the changes in equilibrium price and equilibrium quantity due to
change in supply depend on:

 The size (magnitude) of supply change

 The slope (elasticity) of demand

First, let us consider changes in supply of different magnitude for any given demand curve.
Large change in supply causes large changes in equilibrium price and quantity than a small
change in supply (See the Figure below).

P (a) S0 P (b) S0

S1S1
P0 e0 P0 e0

P1e1 P1e1

38
 0 Q0 Q1 Q 0 Q0 Q1 Q
Figure 2.14: Shifts in Supply in Different Magnitude

In Figure 2.14, the change in supply is large in panel (b) than in (a). Accordingly, the
changes in equilibrium price and equilibrium quantity are larger in (b) than in (a).

Example 2.6

With the demand function in example 2.3 remaining the same at

Qd 100  2 P , suppose the

supply function changes to

Qs 40  4 P .

At equilibrium

100  2 P 40  4 P

6 P 60  P 10

Qd 100  2(10) 80 Qs

The effect of such rise in supply would be fall in price and rise in quantity demanded.

Exercise 2.6
?
P1
The demand function of consumers is given as
Qd 100  2 P . Compare the effects
on equilibrium price and quantity of change in supply

a) From
Qs 10  4 P to Qs 16  4 P .

b) From
Qs 10  4 P to Qs 40  4 P .

How do you explain the differences, if any?

Dear colleague, now consider the effect of difference in the slope of the demand curve on
the changes in equilibrium price and quantity.

P P S0
S0 S1S1

39
 P0 e0P0 e0
P1e1 P1e1
DD

0 Q0 Q1 Q 0 Q0Q1 Q
(a) (b)
Figure 2.15: Effects of Difference in the Slope of Demand

Suppose the shifts in supply in the above two diagrams are equal. For any given shift in
supply, therefore, the higher the change in equilibrium price and the lower the change in
equilibrium quantity will be, the steeper the demand curve. Demand is steeper in (b) than in
(a). Accordingly, the change in price is higher in (b) than in (a), while change in quantity is
higher in (a) than in (b).

Example 2.7

Suppose the supply function has shifted from

Qs 10  4 P to Qs 28  4 P , consider the

equilibrium conditions for demand functions

Qd 100  2 P and Qd 100  5P .

The former demand function represents a steeper demand curve than the later.

The initial equilibrium condition under the two demand functions is

Case 1 Case 2

10  4 P = 100  2 P 10  4 P = 100  5 P

6 P 90 9 P 90

P 15 P 10

Qd 100  2(15) Qd 100  5(10)

Qd 70 Qs Qd 50 Qs

Case 1 Case 2

28  4 P = 100  2 P 28  4 P = 100  5 P

40
6 P 72 9 P 72

P 12 P 8

Qd 100  2(12) Qd 100  5(8)

Qd 76 Qs Qd 60 Qs

The change in price is higher and the change in quantity is lower for the former demand
function (which is steeper) than the latter (which is flatter). Therefore, for any given change
in supply, the effect on price is higher and the effect on quantity is lower the steeper the
demand curve.

Exercise 2.7
?
P1
Suppose the supply functions in two markets, A and B are given as:
QsA 10  4 P

and
Q B
s 10  2 P .The two markets have the same demand function Qd 100  2 P . Now if

the demand function shifts from

Qd 100  2 P to Qd 118  2 P , compare the resulting
changes in the two markets.

How do you explain the differences in the two markets, if any?

2.3.6. Simultaneous Shift in Demand and Supply

Dear learner, in the above two sections, we have seen how price and quantity change as
demand shifts and supply shifts under the ceteris paribus assumption. Under normal
conditions, however, both may change simultaneously. Such types of changes are analyzed
below.
2.3.5.1. Change in Demand and Supply in a Same Direction
Increase in demand shifts the demand curve to the right and exerts an upward pressure both
on price and quantity. Increase in supply, similarly, shifts the supply curve to the right and
exerts a downward pressure on price and an upward pressure on quantity (See the Figure
below).
P S1 S2 P S1

41
 S2

P2 e2
P1 e1 P1 e1
P2 e2

D1 D2 D1 D2

0 Q1 Q2 Q 0 Q1 Q2 Q
(a) (b)
Figure 2.16: Increase in Demand and Supply
Dear colleague, look at the above figure very carefully.
In panel (a), the initial equilibrium is defined at e1. As both demand and supply rise, the
equilibrium point shifts from e1 to e2. Since the rise in demand is greater than the rise in
supply, the net effect will be rise in both price and quantity.
In panel (b), the initial equilibrium position occurs at e1. The shift demand and supply moves
the equilibrium from e1 to e2. Yet, the rise in supply is greater than the rise in demand
resulting in net increase in supply. This reduces the equilibrium price and increases the
equilibrium quantity.

The magnitude by which price and quantity change depends on two factors: the size of
change in demand and supply and the slope of the demand and supply curves. If demand and
supply increase by an equal percentage, price will remain unchanged. The effect of slope
differential will be considered in the next section.

Example 2.8

Suppose the supply function has shifted from

Qs 10  4 P to Qs 28  4 P , and the demand

function has shifted from

Qd 100  2 P to Qd 100  2 P .

Case one below shows the equilibrium before the shift in demand and supply curves and
case two shows the equilibrium after the shift in demand and supply curves.

Case one Case two

Qd1 Qs1 Qd2 QS2

42
 100  2 P 10  4 P 100  2 P 28  4 P

6 P 90 6 P 72

P 15 P 12

Qd 100  2(15) 70 Qs Qd 100  2(12) 76 QS

The effect of the change in demand and supply is fall in price and rise in quantity. This
indicates that the rise in supply is greater than the rise in demand.

Exercise 2.8
?
P1
Suppose the demand function that a firm faces shifted from
Qd 120  3P to

Qd 90  3P and the supply function has shifted from QS 20  2 P to QS 10  2 P .

a) Find the effect of this change on price and quantity.

b) Which of the changes in demand and supply is higher?

43
2.3.6.2. Change in Demand and Supply in an Opposite Direction

Now, let us look at the effect of opposite changes in demand and supply on equilibrium.
Follow attentively.

Suppose demand increases while supply decreases. The rise in demand shifts the demand
curve to the right and the fall in supply shifts the supply curve to the left (See the following
Figure).

P S2 S1 P S2 S1

P2 e2 P2 e2

P1 e1 P1 e1
D2

D1 D2 D1

0 Q2 Q1 Q 0 Q1Q2 Q
(a) (b)
Figure 2.17: Increase in Demand and Decrease in Supply

In Figure 2.17 above, two forces are operating against the equilibrium position. The rise in
demand pushes price up. If supply remained the same, the equilibrium would occur at the
intersection of D2 and S1. This raises the price level. On the other hand, if supply falls with
demand constant, equilibrium occurs at the intersection of D1 and S2. This pushes price up.
Both rise in demand and fall in supply act to raise price. As demand rises and supply falls
simultaneously, price rises to an even higher level (P2).

The effect on quantity, however, depends on the magnitude of the change in demand and the
slope of demand and supply curves. In panel (a) the rise in demand is less than the fall in
supply, therefore, quantity decreases. In panel (b) the rise in demand is greater than the fall
in supply, therefore, quantity increases. If the rise in demand is equal to the fall in supply
quantity will remain unchanged.

44
Example 2.9

Suppose the supply function of a firm has shifted from

Qs 10  4 P to Qs 5  4 P , and the

demand function has shifted from

Qd 100  2 P to Qd 155  2 P .

Case one below shows the equilibrium before the shift in demand and supply curves and
case two shows the equilibrium after the shift in demand and supply curves.

Case one Case two

Qd1 Qs1 Qd2 QS2

100  2 P 10  4 P 155  2 P 5  4 P

6 P 90 6 P 150

P 15 P 25

Qd 100  2(15) 70 Qs Qd 100  2(25) 50 QS

The changes in demand and supply have increased price and reduced quantity. This
indicates that the change in supply is greater than the change in demand.

Exercise 2.9
?
P1 Suppose the demand function that a firm faces shifted from
Qd 100  2 P to

Qd 80  3P QS 10  4 P QS 20  4 P

and the supply function has shifted from to .

a) Find the effect of this change on price and quantity.

b) Which of the changes in demand and supply is higher?

45
4. Elasticity

Both demand and supply are multivariate functions. Any change in their determinants causes
either movement along the curve or shift of the curve. It is often of interest to be able to
measure how demand and supply respond to changes in their determinants. There are
various measures of such responsiveness of demand and supply. The most widely used of
these measures is called elasticity.

Elasticity measures the percentage point responsiveness of demand and supply to a

percentage point in any of their determinants.

Objectives

At the end of this section you should be able to:

 Define and calculate price elasticity of demand;

 Define and calculate price elasticity of supply;

 Define and calculate income elasticity of demand; and

 Define and calculate cross elasticity of demand.

2.4.1 Concept of Elasticity

The determinants of demand and supply may change for a host of reasons. In studying the
effects of factors that affect demand and supply, we are interested not only in the direction
of change but also in the magnitude of the change. With regard to price, the slope of the
demand and supply functions could be considered.

Slope = dQ/dP,

Where, dQ is the change in output and dP is the change in price.

Slope measures by how much output changes for a very small (say a unit) change in price.
In this sense, slope is a measure of responsiveness but it presents some problems. The most
important one is that the slopes of demand or supply functions depend on the units in which
price and quantity are measured. Output could be measured in units, kilograms, litres,
gallons etc while price is measured in currency units such as Birr, Dollars etc. Therefore,
slope measures certain kg per Birr, some liters per Dollar etc. This, in turn, creates problem

46
of comparison where responsiveness is measured in different units. It is not possible to
compare responsiveness measured as X kg/Birr with one measured as Y pounds/Dollar.

Rather than specify units all the time, it is convenient to consider a unit free measure of
responsiveness for this purpose, thus, a measure known as elasticity is often used.

Definition: Elasticity is a measure of the sensitivity or responsiveness of quantity demanded

or quantity supplied to changes in price (or other factors).

Elasticity measures the way one variable (dependent variable) responds to changes in other
variables (independent variables). We express the dependent variable (Y) as a function of the
independent variables (Xi) as in the following function:

Y = f(X1, X2, X3,…,Xn)

In this function, Y is given as a function of n variables. As any one of these variables (Xi)
changes, there will be consequent change in the value of Y.

The formula to determine the responsiveness of Y to changes in the Xi can be expressed as

%Y % Y %Y
1  , 2  , n 
%X 1 % X 2 ………..,
% X n

This formula states that elasticity is the percentage change in the dependent variable divided
by the percentage change in the particular independent variable whose effect is being
examined.

Now, let us look at the elasticity of demand and elasticity of supply separately.

2.4.2. Elasticity of Demand

Colleague, in examining demand, it would be interesting to measure how quantity demanded

responds to changes in price and changes in other factors that affect demand such as price of
other goods and income.

Depending on the variables involved, three measures of elasticity of demand could be

considered:

 Price elasticity of demand measures the responsiveness of quantity demanded to

changes in output price, ceteris paribus.

47
  Cross elasticity of demand measures the responsiveness of quantity demanded to
changes in the price of other goods, ceteris paribus.

 Income elasticity of demand measures the responsiveness of quantity demanded to

changes in consumers’ income, ceteris paribus.

2.4.2.1. Price Elasticity of Demand

Colleague, can you indicate the formula for calculating price elasticity of demand based on
the general formula of elasticity we discussed earlier? We hope so. The price elasticity of
demand () is defined to be the percentage change in quantity demanded divided by the
percentage change in price.

Percentage change in quantity demanded


Percentage change in price

Q / Q

P / P , where Q is change in quantity and P is change in price.

Rearranging

Q P
 
P Q

The sign of the elasticity of demand is generally negative, since demand curves invariably
have a negative slope. Accordingly price elasticity of demand can be stated as:

P
 slope
Q

In elasticity, we consider the absolute value of the coefficients. The negative sign in front of
an elasticity coefficient indicates only that the relationship between price and quantity
demanded is negative. A demand with –2 elasticity coefficient is said to be ‘more elastic’
than the one with –1.

If a good has an elasticity of demand greater than 1 in absolute value, it is said to have an
elastic demand. Such values imply that a given percentage fall in price causes more than
proportionate rise in price.

48
Example 2.10

Assume that a consumer purchases 10 units of a good when price is Birr 4 and 18 units
when price falls to Birr 2. Compute price elasticity of demand.

18  10
100 80%
Percentage change in quantity demanded is 10 and,

2 4
100  50%
Percentage change in price is 4

80%
  1.6
Elasticity, therefore, is given as  50%

This implies that for one percent fall in price quantity demanded rises by 1.6 percent. Here,
since E is greater than one, demand is said to be elastic.

If the elasticity is less than 1 in absolute value, on the other hand, it would be the case of
inelastic demand. This indicates that a given percentage fall in price causes a less than
proportionate rise in quantity demanded.

Example 2.11

Again, assume that a consumer purchases 10 units of a good when price is Birr 4 and 14
units when price falls to Birr 2. Compute price elasticity of demand.

14  10
100 40%
Percentage change in quantity demanded is 10 and

2 4
100  50%
Percentage change in price is 4

40%
    0.8
Price elasticity of demand is  50%

This implies that a one percent fall in price causes a 0.8 percent rise in quantity
demanded.Since elasticity is less than one, therefore, demand is said to be inelastic.

If, however, a given percentage change in price causes a proportionate percentage change in
quantity demanded the elasticity coefficient will be -1; and hence demand is referred to as
unitary elastic.

49
Example 2.12

Assume now a consumer purchases 10 units of a good when price is Birr 4 and 15 units
when price falls to Birr 2. Compute price elasticity of demand.

15  10
100 50%
Percentage change in quantity demanded is 10

2 4
100  50%
Percentage change in price is 4

50%
  1
Price elasticity of demand is, therefore, 50%

With most demand curves, the elasticity coefficient varies along the curve. In this regard, a
good example is a linear demand curve. The coefficients of elasticity of such demand curves
range from perfectly elastic (at the intercept of y-axis) to perfectly inelastic (at the x-axis
intercept).

Consider a linear demand function of the form, Q = a – bP, depicted in the figure below.
The slope of this demand curve is a constant -b.

The formula for price elasticity of demand is given as

dQ P
 
dP Q

P
slope
Q

Substituting this into the formula for elasticity, we have

P  bP
  b  
Q Q

But Q=a-bP

 bP

a  bP

50
The horizontal intercept of the demand curve will be obtained by setting P=0. Accordingly
it occurs at Q=a. The vertical intercept, on the other hand, is obtained by setting Q=0. It is
defined at P= a/b.

P
a/b e = 
e>1
a/2be = 1
e<1
e = 0
0 a/2 a Q
Figure 2.18: Elasticity along a Linear Demand Curve

At the horizontal intercept the price elasticity of demand is zero.

 b ( 0) 0
  0
a  b ( 0) a

When q = 0 at the vertical intercept, the elasticity of demand is infinity.

 bp
  
0

In between these two points, there must be a price-quantity combination at which price
a
P
elasticity of demand is unity or one. This point occurs at 2b .

Proof

The point at which elasticity is unity is defined as

 bP
  1
a  bP

By cross multiplication

 bP bP  a
a 2bP
a 2bp a
  P
2b 2b 2b

51
 a
P
At 2b the quantity demanded will be obtained by substitution into the demand function

Q= a – bP.

a
Q a  b
2b

a a
Q a   Q
2 2

a a
p Q
The price-quantity combination that yields unitary elasticity of demand is ( 2b , 2)

This result implies, therefore, that elasticity of demand for this linear demand function
becomes unitary just half way down the demand curve.

Numerical Coefficients of Price Elasticity of Demand

Colleague, depending on the magnitude (size) of the elasticity coefficient, five types of price
elasticity could be traced along a linear demand curve. Each of these is given in Table 2.8
below.

Table 2.8: Elasticity Coefficients

Numerical coefficients Responsiveness of quantity demanded to changes in price T e r m i n o l o g y

e = 0 n o n e Perfectly inelastic
0 < e < 1 Quantity demanded changes by a smaller percentage than the percentage change in price I n e l a s t i c
e = 1 Quantity demanded changes by a percentage equal to the percentage change in price Unit elastic
1 < e < Quantity demanded changes by larger percentage than the percentage change in price E l a s t i c
e =  Quantity demanded goes to zero or to all that is available perfectly elastic

Exercise 2.10
?
P1 The price elasticity of demand for a 10 percent decrease in price of a commodity is –
5. If the quantity demanded of a commodity by a consumer before price change is 8 units,
what will be the quantity of a commodity demanded by a consumer after a price change in
units?

Determinants of Price Elasticity of Demand

52
Can you list the major determinants of elasticity? Price elasticity of demand depends, in
large part, on the number of substitutes a product has. If a good has many close substitutes,
it is generally held that its quantity demanded would be very responsive to price changes.
On the other hand, if there are a few close substitutes for a good, it will exhibit a quite
inelastic demand.

The elasticity coefficients for general groups of commodities will be lower than for specific
commodities. For example, the elasticity of demand for detergent soap will be higher than
the elasticity of demand for soap in general.

Another determinant of elasticity is time. The longer the period of time consumers have to
adjust, the more elastic the demand becomes. This is because there are more opportunities to
modify behavior and substitute different products over a longer time period.

A fourth determinant of price elasticity of demand is the nature of the need that the
commodity satisfies. Generally luxury goods are price elastic and necessities are price
inelastic.

The proportion of income spent on the particular commodity also affects price elasticity.
Goods like car which take up a large proportion of income tend to have more elastic demand
than goods like salt which take up only small proportion of income.

2.4.2.2. Constant Elasticity Demands

Along a linear demand curve, as shown above, price elasticity of demand ranges between 0
and ∞. In some exceptional cases, the demand curve may exhibit constant price elasticity
throughout.

A demand curve given by a vertical line indicates a case in which the quantity demanded of
a good is totally unresponsive to changes in price. Consequently, the elasticity coefficient is
zero. Such demand curve is called perfectly inelastic demand curve. This is a limiting case,
which violates the law of demand.

dQ P P
  0  0
dP Q Q

P D

53
 P2

P1

0 Q1 Q
Figure 2.19: Vertical Demand Curve

If a demand curve is given by a horizontal line, which is also a limiting case, a very small
decrease in price would cause an infinite quantity of the good to be demanded. If price rises,
in contrary, the quantity of the good falls to zero. Such a curve is referred to as a perfectly
elastic demand curve.

P1 D

0 Q1 Q2 Q
Figure 2.20: Horizontal Demand Curve

A general way to characterize demand curves with constant elasticity is

Q  AP 

whereA is an arbitrary positive constant and  is a measure of price elasticity of demand.

being a measure of elasticity, it will typically take a negative value.

It can be shown that  represents price elasticity of demand.

Proof

 = elasticity

Q P
 
P Q

54
 Q
 AP   1
P
Q
Q  AP e  A 
P
Q Q P
  
P P P
Q P
 
P Q

A more convenient way to express a constant elasticity demand function is to take the
logarithm of both sides and write

ln Q = ln A +  ln P

In this expression, the logarithm of Q depends in a linear way on the logarithm of P.

An interesting case of such constant elasticity demand curves is a unit elastic demand curve.
The demand curve is a rectangular hyperbola. The demand function will, thus, be:

A
Q AP  1 or Q  P

In its logarithmic form, it is stated as

ln q = ln A – ln P

P
P1

P2 D

0 Q1 Q2 Q
Figure 2.21: Rectangular Hyperbola Demand Curve
The price elasticity of demand of a rectangular hyperbola is unitary throughout the demand
curve.

2.4.2.3. Price Elasticity of Demand and Total Revenue

55
Dear colleague, here, we are going to discuss about the concept of revenue and its
relationship with elasticity. Try to follow carefully.

When dealing with demand curves, the concern is with price and quantity relationships.
Quantity, or the number of items sold multiplied by price equals the total revenue generated.

TR P Q

In order to see how firms set and change prices, the relationship between total revenue and
elasticity could be considered.

It is important to recognize that a price change has two opposite effects on total revenue.
The first is that a price decrease, by itself, will decrease total revenue. The other is that with
a price decrease, quantity demanded increases, thus increasing total revenue. The net effect
on total revenue depends on whether the relative price decrease exceeds the relative increase
in quantity demanded or vice versa.

If demand is elastic, fall in price causes increase in total revenue. If, on the other hand,
demand is inelastic, the effect of fall in price would be decrease in total revenue. To see the
principle, consider the figure below.

Price Price

P1P1

P2P2 D

0 Q1 Q2 Quantity 0 Q1 Q2 Quantity

(a) Relatively inelastic demand (b) Relatively elastic demand

Figure 2.22: Elasticity and Total Revenue

On both demand curves, the price falls from P1 to P2 and output increases from Q1 to Q2.
This change causes the total revenue to change. Some revenue is lost and some revenue is
gained due to the price change. In Figure 2.22 above, the lightly shaded areas represent the

56
revenue that has been lost and the darkly shaded areas represent revenue that has been
gained. In the case of the relatively elastic curve, panel (b) of the figure, the decrease in
price has brought about an increase in total revenue; in panel (a), the decrease in price has
brought about a decrease in total revenue.

These relationships are summarized in the table below.

Table 2.9: Relationship between Elasticity and Revenue

Price change Quantity demanded change elasticity total revenue
Rise Decrease > 1 Decrease
Rise Decrease =1 Unchanged
Rise Decrease < 1 Increase
Fall Increase > 1 Increase
Fall Increase =1 Unchanged
Fall Increase < 1 Decrease

Example 2.13

P r i c e . 5 0 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00

Quantity demanded 2 5 2 0 1 8 1 6 1 4 1 2 1 0 8 6 4 2 0

In the table above, at a price of Birr 2.00, the total revenue (TR) is Birr 20.00. An increase in
price form Birr 2.00 to Birr 2.20 causes TR to fall from Birr 20.00 to Birr 17.60. This is
because the 10 percent increase in price caused an even greater percentage decrease in
quantity demanded. The elasticity is greater than one. Conversely, if price rises from Birr
1.00 to Birr 1.20, TR increases from Birr 20.00 to Birr 21.60 because the percentage
increase in price is greater than the percentage decrease in quantity demanded. The elasticity
is less than one.

Total revenue, being the product of price and quantity, its function can be obtained by
multiplying the inverse demand function by the quantity.

A demand function that gives quantity as a function of price (Q = f(P))is called direct
demand function. If the demand function gives price as function of quantity (P = f (Q)), it is
called inverse demand function.

57
An inverse demand function is given as P a  bQ

TR P Q

TR ( a  bQ )Q

TR aQ  bQ 2

Here, total revenue is a quadratic function. At the maximum point of the function its slope is
zero.

The slope of any function is the first derivative of that function.

dTR
a  2bQ
Slope of TR = dQ

At the maximum point of TR, a  2bQ 0

a
Q
2b

Let’s show the relationship between TR and price mathematically.

TR P Q

TR P Q
 Q  P
P P P

TR Q
Q  P
P P

TR  Q P 
Q 1   
P  P Q 

Q P
 
But P Q

TR
Q (1  e )
P

TR
e  1 P  0
If , . This implies that rise in price leads to fall in TR.

58
 TR
e  1 P  0
If , . This implies that rise in price leads to rise in TR.

TR
e 1 P 0
If , . This implies that rise in price will not affect TR.

Example 2.14

1
Qd 50  P
Suppose a demand function is given as 2 . Let’s show that total revenue is

maximum when  = -1.

The inverse demand function is

P 100  2Qd .

2
TR 100Qd  2Qd

dTR
100  4Qd
Slope of TR = dQ d

At the maximum point of TR:

100  4Qd 0

Qd 25

At
Qd 25 price obtained by substitution into the inverse demand function.

P 100  2(25) 50

Price elasticity of demand is defined as:

P
 slope
Q

1 50
    1
2 25

Therefore,  = -1 when TR is maximum

Exercise 2.11
?
P1

59
 Given the demand function
Qd 100  2 P
a) What is price elasticity of demand when TR reaches maximum. Prove your result
mathematically.
b) Find the price and quantity which correspond to this maximum total revenue.

2.4.2.4. Approaches to Elasticity Measurement

Colleague, let us look at the different approaches for measuring elasticity. There are two
main approaches to elasticity computation: the arc elasticity and point elasticity. If we are
measuring the elasticity between points, we are actually calculating the average elasticity
over the space between the points. This is called arc elasticity.

Elasticity between two points:

Q
(Q  Q 2 ) / 2 Q P1  P2
 1  
P P Q1  Q 2
( P1  P2 ) / 2

P1 a

P2 b
D
0 Q1 Q2 Q
Figure 2.23: Arc Elasticity

Suppose you wish to measure price elasticity of demand as price falls from P1 and P2. In this
case you are, in a way, measuring the average elasticity between point a and point b.

Exercise 2.12
?
P1 Find the price elasticity of demand for the demand curve in Example 2.14 if price
changes from Birr 10 to Birr 20. Is demand elastic or inelastic? Explain.

60
When measuring the responsiveness of quantity demanded to changes in price at a particular
point on a curve, you are actually measuring point elasticity.

Elasticity at a point is measured by assuming infinitesimally small changes in price and

quantity demanded. When dealing with the concept of arc elasticity, however, we are
working with sizable, discrete changes.

Elasticity at a particular point:

Q P
 
P Q

P1 a

D
0 Q1 Q

Figure 2.24: Point Elasticity

Price elasticity of demand at a particular point, such as point a, can be obtained by

multiplying the slope of the demand curve at that point by the corresponding price/output
ratio.

P
 slope
Q

Exercise 2.13
?
P1 For the demand function in Example 2.14, find elasticity at price Birr 30.

2.4.2.5. Cross Elasticity of Demand

If you remember, we have said that price of other commodities will affect quantity
demanded of a given product. Now, let us discuss the responsiveness of quantity demanded
to changes in prices of other commodities.

61
The responsiveness of quantity demanded for one commodity to the changes in the prices of
other commodities, ceteris paribus, is called cross elasticity of demand. It is denoted as:

Percentage change in quantity demanded of one commodity (X)

 XY 
Percentage change in the price of another commodity (Y)

In this case (where the demand of a given good does not depend solely on its price), the
demand function is modified in such a way it includes the prices of related goods.

QX = f(PX, PY)

The cross elasticity formula is given as:

Q X PY
 XY  
PY Q X ’

Where QX is the quantity demanded of good X and PY is the price of good Y.

The cross elasticity of demand coefficient may take different values depending on the type
of relationship between the two goods. If cross elasticity demand coefficient is equal to zero,
it would mean the two goods under consideration are unrelated. In this case, any increase or
decrease in price of one of the two goods has no effect on the quantity demanded of the
other good.

On the other hand, if the goods have a relationship of some sort, this value would be
different from zero. The two goods could be substitutes or complements depending on
whether the cross elasticity coefficient is positive or negative.

Definition: two goods are said to be substitutes if one good can be consumed in place of the
other. Complementary goods, in contrast, are goods that are consumed together so that fall
in consumption of one implies reduction in consumption of the other.

If the cross elasticity of demand coefficient has apositive sign it indicates that a rise in the
price of one of the two goods results in rise in the quantity demanded of the other good. As a
result the two goods are substitutes. If, however, the cross elasticity of demand coefficient
has a negative sign, it reflects that a rise in the price of one of the goods results in decline in
the demand for the other indicating that the goods are complements.

62
The size (magnitude) of the cross elasticity of demand coefficient shows strength of the
substitution or complementary relationship between the goods under consideration. i.e., the
higher the value of cross elasticity, the stronger will be the degree of substitutability or
complementarity, depending on the sign.

Example 2.15

The quantity demanded of good X before change in the price of good Y was 25 units. As
good Y’s price changes from Birr 5 to Birr 10, the quantity demanded of good X has
increased to 75 units.

Q X PY
 XY  
PY Q X

50 5
 XY   2
5 25

The two goods, therefore, are substitute products.

Exercise 2.14
?
P1 Use the information in the table below to answer the questions thereof.

P r i c e o f Y Quantity of X

B i r r 5 50 units

B i r r 1 0 25 units
Find the cross elasticity of demand and explain the
relationship between the goods.

2.4.2.6. Income Elasticity of Demand

Dear colleague, let us turn our discussion to the responsiveness of quantity demanded to
changes in income of the buyer.

Income elasticity of demand is a measure of the responsiveness of quantity demanded to

changes in income assuming all other things, including price, constant.

63
 Percentage change in quantity demanded
I 
Percentage change in income

Q I
I  
I Q

Where, Q represents output and I represents consumers’ income.

In measuring income elasticity of demand, the sign of the elasticity coefficient is important.
The sign of the coefficient indicates the nature of the products; whether the products are
normal or inferior.

Definition: normal goods are goods whose quantity demanded increases with rise in
consumers’ income, while inferior goods are those goods whose quantity demanded
decreases with rise in income.

The income elasticity of normal goods is positive reflecting the positive relationship
between income and quantity demanded. For inferior goods, however, income elasticity is
negative.

For normal goods, the same designation for the elasticity coefficients that is used for price
elasticity of demand can be used. If the coefficient is greater than one, I>1, the good is
income elastic, whereas if I <1, the good is said to be income inelastic.

Example 2.16

When the income of the consumer is Birr 1000, the consumer buys 100 units of a good. If
income increases to Birr 1200, the resulting quantity demanded would be 130 units.

The income elasticity demand of the consumer is given as:

Q I
I  
I Q

30 1000
I   1.5
200 100

The consumer’s demand is income elastic.

64
Goods with high positive income elasticity are considered as luxury goods. Necessities in
contrast have low income elasticity. It is important to note at this point that there is no clear
cut range of the income elasticity of demand coefficient for distinguishing between
necessities and luxury goods.

Definition: Luxury goods are normal goods for which quantity demanded changes by a very
high magnitude for a given change in income. Necessities are normal goods whose quantity
demanded changes by a smaller percentage for any given change in income.

Look at the following diagrammatical presentation of the difference in income elasticity

across commodities.
Quantitydemanded

Quantitydemanded

Quantitydemanded
D D
D

0 Income 0 M Income 0 M Income

(a) (b) Normal
(c)good: Normal good: Inferior good
Income inelastic Income elastic beyond M

Figure 2.25: Income Elasticity of Demand

Look at the above figures carefully. In panel a, as income increases, quantity demanded
increases at a decreasing rate. This is reflected by the increasingly flatter demand curve as
the income level increases. In panel b, as the level of income increases, the demand curve
becomes steeper and steeper implying increase in quantity demanded at an increasing rate.
In panel c, however, the demand curve has two segments, a rising segment and a falling
segment. At its rising segment, the demand curve represents the case of income inelastic
normal good. Beyond point M, further increase in income causes fall in quantity demanded
representing a case of inferior goods.

Income elasticity of demand of a good depends mainly on the importance of the product to a
consumer. The more basic a good is in the consumption pattern of a consumer, such as food
stuff, the lower is its income elasticity. The more luxury a good is,the higher its income

65
elasticity will be.Income elasticity also depends on the time period; because consumption
patterns adjust with time-lag to changes in income.

2.4.3. Elasticity of Supply

Dear colleague, as we did for demand, let us now discuss the responsiveness of quantity
supplied to changes in its price.

Price elasticity of Supply

Price elasticity of supply measures the responsiveness of the quantity supplied to a change in
the commodity’s price, ceteris paribus. It is defined as:

Percentage change in quantity supplied

S 
Percentage change in price

Q s P
s  
P Q s
Where, QS is quantity supplied of a good and P is price.
As with price elasticity of demand, if s = 1, supply is unit elastic. If s> 1, it is elastic; and if
s< 1, it is inelastic.

The coefficients of price elasticity of supply are often positive because normally supply
curves are positively sloped. But there are exceptions in which the supply curve is either
vertical or horizontal. If the supply curve is verticalthe quantity supplied does not change
as price changesthen elasticity is zero. This is the case in the very short run where it is
difficult to produce more of a good regardless of what happens to price. Similarly, a
horizontal supply curve has an infinitely high elasticity of supply: a small drop in price
would reduce the quantity producers are willing to supply from an indefinitely large amount
to zero. Between these extremes the elasticity of supply varies with the shape of the supply
curve.

Example 2.17

A firm produces 100 units of output and sells each unit for Birr 20 at equilibrium. Suppose
the demand for the firm’s product has increased and caused a rise in price to Birr 25 a unit.
After the rise in price the quantity that the firm sells has increased to 120 units.

66
 Q s P
s  
P Q s

20 20
s   0.8
5 100

This implies that the supply of the firm is price inelastic.

Exercise 2.15
?
P1 The price elasticity of supply of a firm is 0.5. A rise in price to Birr 6 has induced a
10 percent rise in quantity supplied by the firm. Find the initial level of price.

Determinants of Price Elasticity of Supply

The elasticity of supply depends on:

 How costs behave as output is varied. If the costs of producing a unit of output rise
rapidly as output rises, then the stimulus to expand production in response to rise in
price will quickly be obstructed by increases in costs. In this case, supply will tend
to be rather inelastic. If, however, the costs of producing a unit of output rise only
slowly as production increases, a rise in price that raises profits will bring forth a
large increase in quantity supplied before the rise in costs puts a halt to the expansion
of output. In this case, supply will tend to be rather elastic.

 Time involved. Since as the time period increases, the possibility of obtaining new
and different inputs to increase the supply increases, elasticity of supply tends to be
more elastic over longer periods than over shorter periods.

 Excess capacity and unsold stocks. It may be possible to increase supplies if there is
a pool of unemployed labor and unused machinery. Again, if the industry has
accumulated a large stock of unsold goods, supplies can quickly be increased. These
mean, it is possible to quickly respond to an increase in price by increasing quantity
supplied and hence, supply becomes more elastic.

UNIT THREE

67
 THEORY OF UTILITY AND CONSUMERBEHA
3.Whatis Utility?
Why does a consumer buy a good or service? The answer is: because he obtains satisfaction
from the possession of the good or service. In a technical term, a consumer buys a good or
service because it has utility to him. So that utility defined as follows
Utility is the amount of satisfaction to be obtained from a good or service at a particular
time. For instance, the utility of orange is the satisfaction derived from consuming it at a
particular time. There are some points to note: First, whether the good is useful or not, so far
it gives satisfaction to the consumer, it has utility for him. Second, if a consumer wants
something whether it is good or bad for him, it has utility for him. That is, it may satisfy
socially immoral want, e.g. drug, alcoholism etc. Third, utility of a good varies from person
to person and it varies for the same person from time to time. This implies that utility
depends on the individual's own subjective estimate of the amount of satisfaction to be
derived from a good or service.
The basic concept of utility theory is that consumers are rational beings, it means that
maximize welfare or utility. This derived from choices under less ideal circumstances, near
infinite desire and it also constrained by limited income.
3.1 Consumer Preferences and Choices
Dear learner, in this section you will see how consumers allocate their limited income
among different number of goods and services Moreover, you will learn how consumers
allocation decisions determine quantity demand of goods and services.
After completing this section, you will be able to:

 Describe the theory of consumer preference an choice

 Explain the assumptions of consumer preference

3.1.1Consumer Preference

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Given any two consumption bundles (groups of goods) available for purchase, how a
consumer compares the goods? Does he prefer one good to another, or does he indifferent
between the two groups.
Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent between
the two bundles.
Strict preference

Given any two consumption bundles(X1,X2) and (Y1,Y2),if (X1,X2)>(Y1,Y2) or if he

chooses (X1,X2) when (Y1,Y2) is available the consumer definitely wants the X-bundle
than Y.

Weak preference

Given any two consumption bundles(X1, X2) and (Y1, Y2), if the consumer is indifferent
between the two commodity bundles or if (X1, X2) (Y1, Y2, the consumer would be
equally satisfied if he consumes (X1, X2) or (Y1, Y2).
Completeness

For any two commodity bundles X and Y, a consumer will prefer X to Y, Y to X or will be
indifferent between the two.
Transitivity

It means that if a consumer prefers basket A to basket B and to basket then the consumer
also prefers A to C.

More is better than less

69
Consumers always prefer more of any good to less and they are never satisfied or satiated.
However, bad goods are not desirable and consumers will always prefer less of them.

.3.2. Approaches to measure Utility

1. Cardinal Utility Approach

Objectives

At the end of this section you are expected to:

 State the assumptions of cardinal utility approach;

 Calculate marginal utility from total utility;

 Derive marginal utility curve from total utility curve;

 Determine an individual’s utility maximizing consumption bundle;

 Derive an individual’s demand curve under cardinal utility approach.

 Define consumer’s surplus; and

 Calculate consumer’s surplus from a linear demand curve.

3.1.1. Assumptions of Cardinal Utility Theory

The Cardinal utility approach builds on certain assumptions. The basic assumptions of the
approach are given below.

1. The total utility of a ‘basket of goods’ depends on the quantities of the individual

commodities. If there are n commodities in the bundle with quantities

X 1 , X 2 ,..., X n
the total utility is

U  f ( X 1 , X 2 ,..., X n ) .

This assumption implies that as the quantity of goods consumed increases the total
utility of the consumer accordingly increases.

2. Rationality: the consumer is rational. He/she aims at the maximization of his/her

utility subject to the constraint imposed by his/her given income.

70
 Total utility being the function of the quantity of goods consumed, a consumer
would wish to have more of everything. Yet his/her desire is constrained by his/her
limited income. This brings forth the need to prioritize consumption bundles
according to their desirability.

3. Utility is cardinal: the utility derived from each commodity is measurable. The most
convenient measure is money: the monetary units that a consumer is prepared to pay
for another unit of the commodity measure utility.

4. Constant marginal utility of money: this assumption is necessary if monetary units

are to be used as the measure of utility. If the marginal utility of money changes with
the level of income (wealth) of the consumer, then money cannot be considered as a
measuring rod of utility.

5. Diminishing marginal utility: the extra satisfaction gained from successive units of a
commodity diminishes. In other words, the marginal utility of a commodity
diminishes as the consumer acquires larger quantities of it.

3.1.2. Total Utility and Marginal Utility

Total utility:-is the total amount of utility that consumers receive from consumption of
commodities. Utility being measurable, it is given as the sum of the utilities obtained from
consumption of each unit of the commodity consumed.

Total utility changes as the quantity of the commodity consumed changes. The change in
total utility for a one unit change in the quantity of the commodity consumed is referred to
as marginal utility.

Marginal utility: - is the amount of satisfaction added by an additional unit of consumption.

The formula for marginal utility (MU) is

Change in total utility U  U n 1

MU   n
Change in quantity consumed Qn  Qn 1 .

Where, Un is the total utility from consumption of n units of a good, while Un-1 is the total
utility from consuming n-1 units of the good. UN – Un-1, therefore, measures the extra
satisfaction from consuming the nth unit.

71
Though total utility increases as the consumption increases, the additions to total utility from
each additional unit consumed become smaller. This feature–the fact that additional, or
marginal utility declines as consumption increases–is called diminishing marginal utility
(Consider the following table for more clarification).

Table 3.1: Utility Schedule for Coca Cola

Quantity of Coca Cola Total Utility Marginal Utility

0 0 –
1 2 0 2 0
2 3 8 1 8
3 5 4 1 6
4 6 7 1 3
5 7 7 1 0
6 8 4 7
7 8 8 4
8 8 9 1
9 8 7 - 2
1 0 8 2 - 5

In Table 3.1 above, marginal utility is determined by calculating how much each additional
bottle of Coca Cola adds to total utility. For example, the first bottle adds 20 units to total
utility. The fourth bottle adds 13 units to total utility. This is found by subtracting the total
utility of consuming n-1 bottles from the total utility of consuming n bottles of Coca Cola.

Principle of Diminishing Marginal Utility

The principle of diminishing marginal utility holds that for a given time period, the greater
the level of consumption of a particular commodity, the lower the marginal utility. For
instance, the seventh bottle is expected to provide less additional pleasure than the sixth
bottle. This principle is reflected in table 3.1 and figure 3.1 below. In table 3.1 marginal
utility falls from 20 units for the first bottle to 18 units for the second bottle. The seventh
bottle adds only four units to total utility.

72
Panel (a) of figure 3.1 shows the total utility curve derived from the utility schedule in table
3.1. Panel (b) shows the marginal utility curve that corresponds to the total utility curve.

Total
Utility
100
80
60 Total Utility
40
20
0 1 2 3 4 5 6 7 8 9 10 Quantity of
Coca Cola
Marginal
Utility
20
16
12
8
4
0 1 2 3 4 5 6 7 8 9 10 Quantity of
-4 Coca Cola
-8 Marginal Utility

Figure 3.1: Total and Marginal Utility

Based on the above figures, what is the value of marginal utility when total utility is zero?
Good. Marginal utility is zero when total utility reaches its maximum. The additional utility
(marginal utility) from the consumption of the eighth bottle of Coca Cola is zero. Total
utility, accordingly, reaches its maximum at the eighth bottle of Coca Cola. To the left of
this point marginal utility is positive and total revenue rises. To the right of this point
marginal utility is negative and total revenue falls.

Graphically, MU is the slope of the total utility curve. The slope of total utility curve
decreases until it reaches its maximum point at 8 bottles of Coca Cola. MU, therefore, falls

73
in this range. At the maximum point of the total utility curve slope is zero, and hence MU
will be zero. Beyond the eighth unit, however, since the total utility curve is falling MU is
negative.

Mathematically, MU is given as

dU
MU 
dQ , where dU is change in total utility and dQ is change in the quantity of
the commodity.

3.1.3. Utility and Consumer Behavior

the concepts of utility and price can now be combined to show how consumers make choices
in the marketplace. When choosing, consumers are confronted with a range of items and
also a range of prices. A consumer may not choose the item which has the greatest utility
because price and income are also important factors. In other words, consumers don’t
always buy their first choice. Such behavior is common. You may prefer Teff to Sorghum,
but you may purchase the Sorghum. This is rational behavior, and we can see the reason by
looking at price and utility.

Suppose, for example, you are considering purchasing a soft drink. You are presented with
three possibilities given in table 3.2. Coca Cola is your first choice because it yields the most
utility. But the relevant question is not which soft drink has the most utility, but which has
the most utility per Birr. Therefore, you choose to buy a Pepsi. This choice implies that the
extra satisfaction of Coca Cola over Pepsi is not worth 75 cents, but the extra satisfaction of
Pepsi over Sprite is worth the extra 25 cents it costs. Thus, in deciding how to spend your
money, you look at marginal utility per Birr rather than marginal utility alone. By buying the
commodity with the highest marginal utility per Birr, you economize on your money.

Table 3.2: Hypothetical Utility per Birr Comparisons

C h o i c e Marginal Utility P r i c e MU per Birr

Coca Cola 3 0 3 . 0 0 1 0

74
 P e p s i 2 7 2 . 2 5 1 2

S p r i t e 2 0 2 . 0 0 1 0

1.1.4. Equilibrium of the Consumer

Let us consider consumer’s equilibrium condition.

A consumer is said to be at equilibrium when he/she maximizes his/her utility from the
consumption of commodities for a given price and income. In the simplest case, where the
consumer buys just a single commodity X, he/she is faced with the choice of either spending
his income on the purchase of good X or retaining his/her income. The decision of the
consumer depends on the satisfaction he/she derives from consuming additional unit of the
commodity and the satisfaction he/she derives from keeping his/her income. If consumption
gives him/her more satisfaction than saving, he/she would buy the commodity. If
consumption yields relatively lower satisfaction to the consumer compared to the
satisfaction from saving, then the consumer would keep his/her income. The equilibrium
quantity of the commodity is, then, defined at the equality of the additional utility (marginal
utility) of the commodity and the marginal utility of money (which is assumed to be
constant).

Table 3.3: Utility Schedule for a Single Commodity

Quantity Total utility Marginal utility Marginal utility per Birr (P = Birr 2) Marginal utility of money

1 1 0 - - 1

2 3 6 2 6 1 3 1

3 5 6 2 0 1 0 1

4 7 0 1 4 7 1

5 7 8 8 4 1

6 8 0 2 1 1

7 7 6 - 4 - 2 1

75
 8 6 8 - 8 - 4 1

Table 3.3above presents the utility schedule of a consumer that makes decision on
consumption of beer. Initially each consumed Bottle of beer gives the consumer higher
satisfaction. As the quantity of beer consumed increases, the additional satisfaction received
falls.

For consumption level higher than six bottles, since MU per Birr is higher than the MU of a
unit of Birr, the consumer can increase his/her welfare by consuming more bottles of beer.
For consumption level higher than six bottles, the consumer can improve welfare by
reducing consumption because MU per Birr is less than the MU of a unit of Birr. The
equality of the marginal utility of beer and that of money occurs at the sixth bottle of beer.
This represents the equilibrium of the consumer.

Mathematically, the equilibrium condition of a firm that consumes a single good X occurs
when the marginal utility of X is equal to its market price Px.

MUx = Px

Proof

The utility function is

U  f (X )

If utility is measured in monetary terms and the consumer buys Qx quantity of the
commodity, his expenditure is Qx.Px. The consumer wishes to maximize his utility for any
Birr spent. In a way, therefore, the consumer wishes to maximize the difference between his
utility and his expenditure:

Max
(U  Qx .PX )

The necessary condition for maximum is that the partial derivative with respect to Qx be
zero. This is because, at the maximum point, the slope of the total utility function is equal to
zero.

dU d (Qx Px )
 0
dQx dQx

76
Rearranging we obtain

dU
Px
dQ x orMUx = Px

Exercise 3.1
?
P1 Suppose the marginal utility of a consumer from consuming additional bottle of beer
is 6 units. If the price of a bottle of beer is Birr 3, is the consumer maximizing utility? If not,
what do you think he has to do in order to move towards utility maximizing position?

If MUx is greater than Px, the consumer can increase his welfare by purchasing more units of
X. If, on the other hand, MUx is less than Px, the consumer can increase its welfare by
reducing the quantity of x he purchases. Utility is maximized when the condition MUx = Px
is satisfied.

Suppose now the consumer faces two commodities in his utility function, Pepsi and Pizza.
The price of Pepsi is Birr 2 a unit and that of Pizza is Birr 3 a unit. The utility schedule of
the consumer is given below (See Table 3.4).

Table 3.4: Utility Schedule for Two Commodities

P e p s i P i z z a

Quantity T U M U MU/P (P = 2) Quantity T U M U MU/P (P = 3)

1 3 2 3 2 1 6 1 4 5 4 5 1 5

2 5 8 2 6 1 3 2 8 7 4 2 1 4

3 7 8 2 0 1 0 3 1 2 0 3 3 1 1

4 9 2 1 4 7 4 1 4 7 2 7 9

5 1 0 0 8 4 5 1 6 5 1 8 6

6 1 0 2 2 1 6 1 7 7 1 2 4

7 9 8 - 4 - 2 7 1 8 3 6 2

8 9 0 - 8 - 4 8 1 8 3 0 0

77
Budget Constraint

Dear colleague, can you buy whatever quantity of a product want to buy? Why? Did you say
I have limited money? Good. That means you have a budget constraint. The consumer has a
given amount of income and hence we call he has a budget constraint.

Definition: budget constraint shows the given level of income that determines the maximum
amount of goods that may be purchased by an individual.

For example, let’s consider the consumer with Birr 28 worth of purchasing power, and see
how that income will be allocated between the two goods so as to achieve maximum utility.

The consumer first buys a unit of Pepsi, because the first unit of Pepsi yields 16 units of
satisfaction per Birr. The next commodity purchased would be pizza, because it yields 15
units of satisfaction compared with the 13 units for Pepsi. The third commodity purchased
will be pizza, because it yields higher satisfaction per Birr than the second unit of Pepsi.
This process continues until the income of Birr 28 is spent. In maximizing utility, the
consumer will buy 5 units of Pepsi (spends Birr 10 on Pepsi) and 6 units of pizza (spends
Birr 18 on pizza). This allocation gives a total of 277 units of satisfaction–the maximum
utility that can be obtained for an expenditure of Birr 28.

At this level of allocation the marginal utility per Birr is equal for the two commodities. If
there is any difference in the MU/P, the consumer can increase its welfare (total utility) by
consuming more of the commodity that gives him/her more MU/P, and consuming less of
the commodity that gives him/her less MU/P.

This condition can be defined in algebraic form as:

MU Pepsi MU pizza

PPepsi Ppizza

Thus, the marginal utility of a bottle of Pepsi, when 5 bottles of Pepsi are consumed is 8
units, and the price of Pepsi is Birr 2, so

MU Pepsi 8
 4
PPepsi 2
,

78
or 4 units per Birr. For pizza, at the optimum consumption rate MU is 12 units and the price
is Birr 3, so

MU pizza 12
 4
Ppizza 3
.

This can be generalized to show the consumption decision involving n commodities. In this
case, the condition for the consumer’s equilibrium is defined by the equality of the ratios of
marginal utilities of individual commodities to their prices.

MU x MU y MU z
 ... 
Px Py Pz

The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he/she can
increase his welfare by spending more on that commodity and less on others.

Exercise 3.2
?
P1 Suppose that the prices of good A and good B are Birr 3 and Birr 2 respectively.
Suppose a consumer is spending his entire income for buying 4 units of A and 6 units of B,
and the marginal utility of both the 4th unit of A and the 6th unit of B is 6. Is the consumer at
his optimal position? Explain your answers?

Weaknesses of Cardinal Utility Approach:

The cardinal approach involves two serious weaknesses, namely:

 The assumption of cardinal (measurable) utility is doubtful. The satisfaction derived

from the consumption of various commodities cannot be objectively measured.

 The assumption of constant utility of money is also unrealistic. The utility derived
from a unit of money varies with the level of income of the consumer. The additional
satisfaction that a poor person derives from a unit of money is by far higher than the

79
 marginal utility of a rich person. Thus, money cannot be used as a measuring rod
since its own utility changes.

1.1.5. Consumers’ Surplus

A demand curve shows the price consumers are willing to pay for an additional unit of a
commodity. The negative slope of the demand curve reflects the law of diminishing
marginal utility. Consumers wish to pay less and less to additional units of commodity
because the additional utility that extra units of a commodity yield tend to be lower as
the quantity of the commodity consumed increases.

In a market economy, consumers pay the same price to all units of a commodity purchased,
though they are willing to pay different units. The difference of the price that consumers are
willing to pay and the price they actually pay constitutes consumer’s surplus.

Consumer’s surplus is the extra utility gained from the fact that some consumers pay less for
an item than they would be willing to pay for the item.

Consider the demand curve in Figure 3.4 below. At price P1, the consumer will consume Q1
units of the commodity. From the discussion of utility maximizing behavior, the marginal
utility of the last unit purchased is equal to the price of the unit. This means that the
marginal utility of each previous unit purchased was greater than price P1. The consumer
would have been willing to pay higher prices for those previous units. So at the market price
of P1, the consumer receives extra utility on all units but the last one. The total purchase is
worth more to the consumer than the total amount that is paid. This extra utility gained is
called consumer’s surplus and is represented by the area below the demand curve and above
the market price. The shaded area in Figure 3.4 below represents consumer’s surplus.

Consume
r surplus
P1

0 Q1 Q

80
 Figure 3.4: Consumers’ Surplus

Geometrically, consumer’s surplus is given as ½ ( P  P1 )Q1 .

Example 3.1

Suppose demand and supply functions are given as

Qd 100  2 P and Qs 10  4 P
.Equilibrium price is 15 and equilibrium quantity is 70. The vertical intercept of the demand
curve is at P = 50. Consumer’s surplus at equilibrium is, then,

CS = ½ (50  15) 70 1225

Exercise 3.3
?
P1 Suppose the supply function of consumers for a particular good in a given market is
Q=-9+3P, while the demand function of the firms in that market is Q=16-2P. Find the
consumer’s surplus at the equilibrium point.

2. Ordinal Utility Approach

The ordinal utility approach emphasizes that for decision making it suffices if consumers
can rank their preferences according to their desirability, rather than specify the quantity of
utility they derive from consumption of a commodity. For example, instead of saying that a
unit of Pepsi gives me 30 units of utility and a unit of pizza gives me 20 units of utility,
therefore I prefer Pepsi to pizza; the consumer needs only to be able to say “I prefer a unit of
Pepsi to a unit of Pizza.” Ordinal utility involves a utility ranking that only requires that
choices be ranked, rather than assigned numerical values.

Objectives

At the end of this section, you will be able to:

 State the assumptions of ordinal utility approach;

 Define an indifference curve and a budget line;

81
  Derive an income-consumption curve and price-consumption curve using
indifference curve analysis;

 Determine an individual’s utility maximizing consumption bundle;

 Derive an individual’s demand curve using indifference curve analysis; and

 Derive the income effect and substitution effect.

3.2.1. Assumptions of Ordinal Utility Theory

Colleague, like we did for cardinal utility, here also we will start with the assumptions of
ordinal utility. These assumptions are the following:

1. The consumers are assumed to be rational- they aim at the maximization of their
utility, given their income and market prices.

2. Utility is ordinal- it is assumed that consumers can rank their preferences according
to the satisfaction of each bundle. They need not know precisely the amount of
satisfaction. It suffices that they express their preference for the various bundles of
commodities.

3. The total utility of the consumer depends on the quantities of the commodities

consumed. The utility function is, thus, given as

U  f (Q1 , Q2 ,..., Qn ) .

4. For any two consumption bundles A and B, the consumers are able to determine the
bundle that provides the most satisfaction:

 A is preferred to B if it provides more satisfaction than B. Conversely B is

preferred to A if it provides more satisfaction than A.

 If both bundles provide equal level of satisfaction the consumer would be

indifferent between the two bundles.

5. Preferences are transitive- if A is preferred to B and B is preferred to C, then A is

preferred to C. Similarly if the consumer is indifferent between A andB and if he is
indifferent between B andC, then he is indifferent between A andC.

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3.2.2. Preference Ranking

The basis of ordinal utility approach is its assumption that objective measurement of utility
is largely impossible and unnecessary as long as people are able to rank one consumption
bundle ahead of another. Table 3.5 below shows the ranking of eight consumption bundles
by a consumer that consumes two goods X and Y. The consumer assigns rank to each bundle
according to the importance of the bundles to his satisfaction. In this example, more
preferred bundles are assigned higher values. A commodity spaceis obtained by plotting the
table on a two dimensional plane. Each point in the commodity space describes an allocation
of X and Y. So at point F, the consumer is considering the allocation of one unit of X and
four units of Y. To say that the consumer is indifferent between F and G implies that he is
indifferent between the bundle 1X and 4Y and bundle 2X and 2Y. It does not imply that he is
indifferent between 4Y and 1X(See the table).

Table 3.5: Rank Ordering of Commodity Bundles

Bundle Amount of X Amount of Y Rank order

A 6 6 4
B 3 5 3
C 4 3 3
D 5 2 3
E 3 4 2
F 1 4 1
G 2 2 1
H 3 1 1

From the table, we can see that consumption bundle Ahas more of both goods X and Y, and
hence, is preferred to all other bundles. The consumer is indifferent among consumption
bundles B, C, and D, indicating that the consumer is willing to take less Y if he gets enough
more X in return. Bundle B is preferred to E (the latter has less Y and the same amount of X).
The consumer is also indifferent between bundles G, H, and F.

7
Quantityof Y

6 A(6, 6)
5B(3, 5)
4 F(1, 4)E(3, 4)
3C(4, 3)

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 2G(2, 2) D(5, 2)
1H(3, 1)
0 1 2 3 4 5 6
Quantity of X
Figure 3.5: Commodity Space

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Utility Functions

Utility function is a preference function ordering a consumer’s desire to consume differing

amounts of commodities.

The use of utility functions, that assign numerical value or utility level to consumption
bundles, facilitates the analysis of consumer behavior. Utility functions provide ordinal
measurement of the utility provided by consumption bundles, i.e., the particular values
assigned to consumption bundles do not have significance on their own right. They are
simply used for the purpose of ranking different consumption bundles. If the consumer
prefers bundle A to bundle B, the utility function has to assign a larger numerical value to
bundle A than to bundle B, but the actual numerical values so assigned are themselves
irrelevant. Similarly, if the consumer is indifferent between bundle A and bundle B, the
utility function must assign the same numerical value to each bundle, but the particular value
so assigned is irrelevant. For example, the rank order assigned to consumption bundles A
through H in Table 3.5 can be thought of as the numerical values assigned to these bundles
by some utility function. Any other set of numbers such as 50, 20, 20, 20, 5, 3, 3, 3, which
preserved this ranking would do equally good.

If a utility function is defined as U  XY , utility is the product of the quantities of X and Y

consumed by consumers. In this case, the consumer derives 100 units of utility from a
bundle consisting of 10 units of X and 10 units of Y. And he/she is indifferent between a
bundle, which consists of 1 unit of X and 100 units of Y and 10 units of X and 10 units of Y.
A bundle with 1 unit of X and 100 units of Y is preferred to a bundle with 8 units of X and 10
units of Y.

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3.2.3. The Indifference Curve

Here, we will discuss about indifference curve which is very important in ordinal utility
theory. Consumers’ preferences are such that they choose the best things they can afford.
Consumers have consumption bundle which represents the complete list of the goods they
prefer. These consumption bundles are represented by (X, Y), where X represents the good of
our particular interest and Y all other goods.This enables us to focus on the tradeoffbetween
one good and everything else. Consumers can rank these bundles according to their
desirability.

In a consumer choice problem involving two consumption bundles (X1, Y1) and (X2, Y2), if
the individual

 always prefers the former bundle to the later, we say (X1, Y1) is preferred to (X2, Y2).

 Is equally satisfied with both bundles, then the consumer is indifferentbetween the
two bundles.

An indifference curve is a locus of points–particular combinations or bundles of goods–in a

commodity space, which yield the same utility to the consumer, so that heis indifferent
between the different consumption bundles. Each point on an indifference curve yields the
same total utility as any other point on that same indifference curve.

If the utility function is given by U(X1, X2,…, Xn), where X1 is the amount of good 1
consumed, X2 the amount of good 2 consumed, and so on, then an indifference curve is
defined as the set of all consumption bundles (X1, …, Xn) that satisfy the equation
U(X1, X2, …, Xn) = C, where C is the constant level of utility for that indifference curve.

If on an indifference curve C is 5, then each point on the same indifference curve will yield
just 5 units of utility. If on another indifference curve C is 20, each point on this indifference
curve yields a higher level of utility to the consumer than any one point on the previous
indifference curve. Therefore, bundles on the later indifference curve will be preferred to
bundles on the former indifference curve. A set of indifference curves is called indifference
map.

Definition: An indifference map is a set of indifference curves each corresponding to a

different level of satisfaction for the consumers.

86
The indifference curvesin an indifference map rank the preferences of the consumer.
Combinations of goods situated on an indifference curve yield the same utility.
Combinations of goods lying on a higher indifference curve yield higher level of satisfaction
and are preferred. Combinations of goods on a lower indifference curve yield a lower utility,
and, therefore, are not preferred.An indifference map is generated by choosing different
values for C in the expression U(X1, X2, …,Xn) = C(See the figure below).

YY

III
II
I
0 X 0 X
(a) Indifference curve (b) Indifference map

Figure 3.6 Indifference curve and Indifference map

Example 3.2

Assume that a consumer’s utility function is given as U  XY . A consumption bundle with

6 units of X and 10 units of Y and a bundle with 12 units of X and 5 units of Y yield the same
level of satisfaction (60) to the consumer, therefore, lie on the same indifference curve. A
bundle with 8 units of X and 8 units of Y, however, is preferred to both bundles because it
yields a higher level of satisfaction, therefore lies on a higher indifference curve.

3.2.3.1. Characteristics of Indifference Curves

The following are the major characteristics of an indifference curve:

1. An indifference curve has negative slope, which denotes that if the quantity of one
commodity (Y) decreases, the quantity of the other (X) must increase, if the consumer
is to stay on the same level of satisfaction. If the quantity of one commodity
increases with the quantity of the other remaining the same, the total utility of the
consumer increases. Conversely, if the quantity of one commodity is reduced with

87
 the quantity of the other remaining the same, the total utility of the consumer
decreases. Therefore, in order to keep the utility of the consumer constant, as the
quantity of one commodity is increased, the quantity of the other must be reduced.

2. Consumers can compare any two bundles in the commodity space and decide that he
prefers one of them or is indifferent between them. Therefore, there is an
indifference curve passing through each point in the commodity space. In a
commodity space, there are infinite points that represent consumption bundles. Some
of these bundles yield equal amount of satisfaction to the consumer, and hence are
located on the same indifference curve. Each point gives some amount of satisfaction
to the consumer, therefore, must be located on certain indifference curve.

3. The farther from the origin an indifference curve lies, the higher the level of utility it
denotes: bundles of goods on a higher indifference curve are preferred by the rational
consumer. Consumption bundles on a relatively lower indifference curve, in
contrary, represent lower level of satisfaction and are not preferred by a rational
consumer.

4. Indifference curves do not intersect each other. If they did, the point of their
intersection would imply two different level of satisfaction, which is impossible.

K
a d

b
c I
e II
0 L
Figure 3.7: Intersection of Indifference Curves

Points a, b and c are located on the same indifference curve, therefore must represent
the same level of utility. Similarly, points d, b and e are located on the same
indifference curve, therefore must yield the same level of utility. Bundle b is located
at the intersection of two indifference curves implying two different levels of
satisfaction. Bundle a has equal quantity of Y as bundle d, but it has more of X than

88
 d, therefore represents higher level of utility. Both a andd, however, yield the same
level of satisfaction as bundle b. This implies that a anddyield the same level of
utility, which is not true.

5. Indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the
left downwards to the right.

3.2.3.2. Extreme Indifference Curves

Colleague, we have special cases of indifference curves. The shape of the indifference
curves in Figure 3.6 above is considered to be typical for most goods. A typical indifference
curve has a negative slope and is convex to the origin. To understand why this shape is
typical, let’s look at two extreme shapes. One extreme is shown in Figure 3.8 below, where
each indifference curve is a straight line. On indifference curve I3, the individual is
indifferent among all combinations between 40 units of Y and no X, and 20 units of X and no
Y. For instance, this person is indifferent between a bundle made up of 20Y and 10X and a
bundle made up of 10Y and 15X. We can generalize and say that the consumer is indifferent
between all combinations offering two units of Y in compensation for the loss of one unit of
X. They all yield the same amount of satisfaction. The tradeoff is always two Y for one X.

Y
40
I3
30
I2
20
I1
10

0 10 15 20 X

Figure 3.8: Linear Indifference Curves

The equation for I3 is Y 40  2 X . In this case, the slope is -2, meaning that two units of Y
will compensate the consumer for the loss of one unit of X. Remember that since this is an

89
indifference curve, any point on the curve has the same utility as any other point on the
curve. The equation for I2 is Y 30  2 X and for I1, Y 20  2 X . Obviously I3 is preferred
to I2, andI2is preferred to I1.

Indifference curves like this could happen only if the two commodities, X and Y, are the
same commodity except for the units in which they are expressed. Thus, Y could be a one-kg
bag of sugar and X, a two-kg bag of sugar. This demonstrates that perfect substitutes have
linear indifference curves and that the closer two commodities are to being perfect
substitutes, the closer the indifference curves are to being straight line.

The extreme opposite of the linear indifference curve is the indifference curve with right
angle, as shown in Figure 3.9 below. To see the significance of this, look at I1. I1 indicates
that the consumer is indifferent between having two units of X and two units of Y, and
having two units of X and three units of Y, or indeed, two X and any number of Y, additional
units of only one of them would contribute nothing to additional satisfaction.

Such products are perfect complements, and good examples are left shoe and right shoe.
This is a trivial case since perfect complements are combined and sold as one good. We can
observe from this, however, goods that are complements to each other will have indifference
curves which approach the right-angled ones, being very convex to the origin, and almost
parallel to the axes.

5
4
3 I2
2 I1
1

0 1 2 3 4 5 6 X

Figure 3.9: Right Angled Indifference Curves

The typical indifference curve for two goods, as shown above, will lie between the extremes
of perfect substitutes and perfect complements.

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3.2.4. Marginal Rate of Substitution

Colleague, let us see the concept associated with the slope of an indifference curve: marginal
rate of substitution. Marginal rate of substitution is a measure of substitution of two
commodities in consumption.

Definition: Marginal rate of substitution of X for Y is defined as the number of units of

commodity Y that must be given up in exchange for an extra unit of commodity of X so that
the consumer maintains the same level of satisfaction.

Number of units of Y given up

MRS X ,Y 
Number of units of X gained

Graphically, it is measured by the slope of an indifference curve. As we move from left to

right on an indifference curve, the marginal rate of substitution decreases in absolute value;
this is referred to as the decreasing marginal rate of substitution (See the figure below).

As a consumer receives more and more of a particular good, its value in terms of other
goods declines.This implies that the number of units of commodity Y that the consumer is
willing to sacrifice for additional unit of commodity X declines as the quantity of X
increases.

Y
8 a
7
6
5
4
3 b
2
1

0 1 46 25 50 X

Figure 3.10: Marginal Rate of Substitution

At point a in Figure 3.10, the consumer consumes 4 units of X and 8 units of Y. At this point
X is relatively scarce and Y is relatively abundant. Therefore, the consumer is willing to give

91
larger quantities of Y in exchange for a unit of X, or, in other words, he is willing to give
fewer quantities of X in exchange for a unit of Y. Here, the consumer is willing to trade 2
units of X for a unit of Y. At point b, however, the consumer has more of X and less of Y,
thus is willing to exchange fewer quantities of Y in exchange for a unit of X. Now, he is
willing to trade 25 units of X for a unit of Y. Any movement along the indifference curve
from left to right results in reduction in the rate of exchange between the two commodities.

dY Slope of
 MRSindifference
= dX = X ,Y
curve

MRS X ,Y MRS Y , X
Here, it is important to note that is different from . The former measures
the quantity of Y that must be sacrificed for a unit of X so as to keep the consumer at the
same level of satisfaction. The later measures the quantity of X that must be given up for a
unit of Y in consumption such that the consumer will remain at the same level of utility.

The concept of marginal utility is implicit in the definition of marginal rate of substitution,
since marginal rate of substitution is defined by the ratio of marginal utilities of the
commodities involved. This reflects the fact that the consumer takes into account the
additional (marginal) utility of the two commodities when making the exchange.

MU X MU Y
MRS X ,Y  MRSY , X 
MU Y or MU X

Proof:

The utility function involving two commodities X and Y is defined as

U = f (X, Y).

Along an indifference curve utility is constant, therefore

U = f(X, Y) = C

The total differential of the utility function is

92
 U U
dU  dX  dY 0
X Y
MU X dX  MU Y dY 0
MU X dY
 MRS X ,Y
MU Y dX

Similarly,

MU Y dX
 MRSY , X
MU X dY

The ratio of the marginal utilities of the two commodities defines the rate at which one is
substituted for the other in consumption.

Example 3.3
0.4 0.6
Suppose a consumer’s utility function is given as U 20 X Y and we are required to find
MRSX, Y.

MU X
MRS X ,Y 
MU Y

dU dU
MU X  MU Y 
dX , and dY

MU X 0.4(20 X ( 0.4 1)Y 0.6 ) , and MU Y 0.6(20 X 0.4Y ( 0.6 1) )

MU X 8 X  0.6Y 0.6 , and MU Y 12 X 0.4Y  0.4

MU X 8 X  0.6Y 0.6
MRS X ,Y  
MU Y 12 X 0.4Y  0.4

2Y
MRS X ,Y 
3X

Exercise 3.4
?
P1 0.8 0.2
Find the MRSX, Y and MRSY, Xif a consumer’s utility function is U 50 X Y . Is there
any difference between the two? Explain your answers.

93
3.2.5. The Budget Constraint

Now, let us look at the budget constraint discussed under cardinal utility approach but in a
different way. As seen in the preceding sections, the utility of a consumer depends on the
quantities of the commodities consumed. If so, then, a rational consumer must wish to
acquire as much quantities of the commodities as possible. Yet, the quantity of the
commodities that a consumer can acquire at a given time is limited by hisincome. Given the
infinite consumption bundles in a commodity space, those bundles that can be afforded by a
consumer for a given money income constitute the affordable consumption bundle of the
consumer. The size of the consumer’s income, therefore, defines the consumer’s affordable
consumption bundle.

Suppose the consumer consumes two goods X1 and X2 with their prices given as P1 and P2.
If the total income of the consumer is M, the total expenditure of the consumer cannot
exceed his total income.

P1 X 1  P2 X 2 M

The set of all affordable consumption bundles at a given income M and prices P1and P2 is
referred to as the budged set of the consumer. The relationship between expenditure and
income above defines the consumer’s budget set. The boundary of this set is called the
consumer’s budget constraint.

Definition: budget constraint is the set of consumption bundles that can be purchased if the
entire money income is spent, for a given commodity prices. It is shown by the equality of
expenditure with income.

P1 X 1  P2 X 2 M

Solving for X2 gives the equation of the budget constraint.

P2 X 2 M  P1 X 1
1 P
X2  M  1 X1
P2 P2

The budget constraint establishes the maximum possible combination of goods X1 and X2that
the consumer can acquire for income M and prices P1 and P2.The slope of the budget line is

94
 P1
( )
the negative of the ratio of the prices of the commodities involved
P2 . The negative sign

reflects the downward slope of the budget line, which implies that when the entire income is
used so as to increase the consumption of one commodity, the consumer must reduce the
consumption of the other.

The shaded area in Figure 2.11 shows the different consumption bundles that the consumer
can afford to purchase for a given income M, while the boundary of this region, the budget
constraint, shows the highest possible bundles that can be afforded for the given income M.
The budget line has the following characteristics.

 Points on the budget line, such as point a, indicate consumption bundles that use up the
household’s entire income. Once a consumer locates himself on any one point on the
budget line, he can only increase the consumption of one commodity by reducing the
consumption of the other, because the entire income has been spent.

X2
M/P2 b
a
Budget constraint
c

Budget set

0 M/P1 X1

Figure 2.11 Budget Set and Budget Line

 Points below the budget line, such as c, indicate combinations of commodities that cost
less than the household’s income. When an individual consumes a consumption bundle
inside the budget set, since there is income which is not spent, it is possible to improve
utility by increasing consumption.

 Points above the budget line, such as b, indicate combinations of commodities that cost
more than the household’s income.Points outside the budget set are not attainable for a
given income, and are irrelevant for decision making.

95
Shifts in the Budget Line

Dear colleague, can you list the factors that are responsible for the shift in the budget line?
Ok. Let us see it together.

The budget constraint sets upper limit to the quantities that a consumer wishes to buy. This
constraint gets relaxed or tightened as certain conditions change. Such changes are reflected
by shift of the budget constraint. These shifts may result from two sources, namely:

 Changes in the consumer’s income. As the income of the consumer changes, the
consumer can buy more of or less of both commodities depending on the direction of
the change.

 Changes in the prices of the commodities. Such changes have the effect of making
the commodity whose price has fallen relatively attractive and at the same time
raising the real income of the consumer.

3.2.5.1. Changes in Money Income

With two goods, X1 and X2 involved, increase in income enables the consumer to purchase
more of good 1, more of good 2 or more of both goods. Given the budget equation:

1 P
M  1 X1
X = P2
2
P2

The vertical intercept is M/P2 and the horizontal intercept is M/P1. The intercepts show the
quantity of one of the commodities that would be bought by the consumer if the entire
income is spent on the purchase of a single commodity. For example, if the entire income is
spent on the consumption of X2, the total quantity purchased of X2 would be M/P2.

Increase in income changes the vertical intercept and the horizontal intercept. It does not
affect the slope of the budget line (the ratio of prices). As a result, change in consumer’s
income causes an outward shift of the budget line in a parallel fashion.

96
 X2
M*/P2
M/P2

X 22 b

X 21 a

0
X 11 X 12 M/P1 M*/P1 X1
Figure 2.12: Change in Money Income

Suppose initially the consumer’s income is defined at M. The budget constraint of the
consumer is given by the line with vertical intercept and horizontal intercept M/P1 and M/P2
respectively as in Figure 2.12. At point a on the initial budget constraint, the consumer can

buy
X 11 of X1 and X 21 of X2. If now the consumer’s income rises to M*, the consumer will be
able to buy more of both goods at the new income condition. In the figure above, the budget
constraint with intercepts M*/P1 and M*/P2 represents the new income condition. At point b

on the new budget line the consumer can buy

X 12 of X1 and X 22 of X2. Bundle b has more of
both commodities than bundle a, therefore the consumer’s position is improved after the rise
in income. A decrease in income, on the other hand, causes a parallel shift to the left of the
budget line. When such changes exist the consumer will be forced to a lower utility position,
because he will have to buy less of one of or both of the commodities at the lower income.

Example 3.4

Suppose a consumer’s income is Birr 280 and uses this income to buy two goods X and Y. If
the price of X is Birr 2 a unit and that of Y is Birr 5 a unit, the budget equation can be stated
as

97
 2 X  5Y 280

Solving for Y,

Y 56  0.4 X

The slope of the budget line is, then -0.4. The vertical intercept is obtained by setting X = 0,
and it is defined at Y = 56. The horizontal intercept, similarly, is obtained by setting Y = 0,
and it is X = 140. Now if the consumer’s income increases to Birr 350, with commodity
prices remaining the same, the new budget equation is given as

2 X  5Y 350 .

Solving for Y,

Y 70  0.4 X

The slope of the budget line is unchanged, but the vertical intercept has increased to Y = 70
and the horizontal intercept has increased to X = 175. Here both the vertical intercept and the
horizontal intercept have risen by 25 percent. Therefore, the budget line must have shifted in
a parallel fashion.

98
Exercise 3.5
? A consumer’s income is Birr 400. The consumer uses his entire income to buy two
P1 X and Y. If the price of X is Birr 2 and the price of Y is Birr 4, derive the consumer’s
goods
budget equation. Find the effect of fall in income to Birr 300 on the vertical intercept,
horizontal intercept and slope of the budget line.

3.2.5.2. Changes in Price

Colleague, we have discussed that the prices of the commodities
determine the quantities of the commodities purchased for a
given money income. This fact is reflected in the budget
constraint. The slope and intercepts of the budget line are
affected by changes in the prices of the commodities. The
changes in price could be of two types: proportional change in
price, in which the prices of the two commodities rise or fall by
the same percentage such as by change in the general price
level, or relative change in price, in which the prices of the two
commodities change by different percentages.
Proportional Changein Prices
Proportional rise in the prices of both goods (good 1 and good 2), with income remaining
unchanged, will reduce the total quantity of the two goods that the consumer can buy for a
given income. For example, if the prices of the two goods under consideration double, this
would halve the quantities of the two goods purchased to be reduced by half.Before the rise
in price, if the consumer decides to spend his entire income on X1, the total quantity
purchased is M/P1. But after the doubling of prices, the new quantity will be M/2P1. The new
quantity is half that of the pre change quantity. Its effect is the same as that of reducing the
consumer’s income by half. This causes a parallel shift in the budget line towards the origin.

Proportional rise in the prices of the two commodities, X1 and X2 causes fall in the intercepts
but leaves the slope of the budget line unchanged.

99
X2

M / P2''
M/P2

M / P2'

0
M / P1' M/P1 M / P1'' X1

Figure 3.13: Proportional Changes in Price

Suppose the initial budget constraint is the one with intercepts M/P1 and M/P2. Proportional
'' ''
fall in price shifts the budget line to the right to the one with intercepts
M / P1 and
M / P2

.On the other hand, a proportionate fall in price is shown by shift of the budget line to the
right. In this case, with income remaining the same, the intercepts increase but the slope
remains unchanged. In Figure 3.13, a proportional rise in price is shown by shift of the

budget line from the one with intercepts M/P2 and M/P1 to the one with intercepts
M / P1' and

M / P2' .

Example 3.5

Suppose a consumer’s income is Birr 300. The consumer spends his income in the
consumption of two goods X and Y with prices Birr 5 and birr 10 respectively. Assume
further that the consumer buys equal quantity of both goods. In this case, by exhausting his
entire income the consumer can buy 20 units of X and 20 units of Y.

5(20) + 10(20) = 300

If the price of both goods doubles; i.e., Px = 10 and Py= 20, the quantity that the consumer is
able to buy when the entire income is spent is reduced to 10 units of X and 10 units of Y.

10(10) + 20(10) = 300

100
 Exercise 3.6
?
P1 Suppose a consumer uses his entire income, which is Birr 180, for the purchase of
two goods X and Y. The prices of the two goods X and Y are Birr 6 and Birr 12 respectively.
If the two goods are complementary and are used in the proportion of one-to-one, find the
effect of fall in price of the two goods to Birr 2 and birr 4, respectively, on the budget
constraint.

Changes in Relative Prices

Colleague, a change in relative price can occur, and often does, as a result of changes in only
one of the prices or changes in both prices in different proportions.

First, assume that the price of good 1 changes (increases) with price of good 2 and income
remaining fixed. Slope being the ratio of prices, this would make the budget line steeper.
The vertical intercept does not change, but the horizontal intercept will change. The
'
P1

resulting new slope would be P2 where P1' is the new price of good 1.

X2
M/P2
Slope= -P1/P2

Slope=
 P1' /P2

0
M / P1' M/P1 X1
Figure 3.14: Relative Changes in Price

In Figure 3.14 above, the initial budget constraint is the one with intercepts M/P1 and M/P2
and slope -P1/P2. With the price of X2 and income (M) remaining unchanged, if the price of
X1 rises, the budget line rotates towards the origin. The horizontal intercept of the budget
line decreases, reflecting the fact that as the price of X1 rises the quantity of X1 that can be
bought by the consumer declines if he decides to spend the entire income on X1. Thus, the

101
new horizontal intercept is
M / P1' . Similarly slope decreases to  P1' /P2. The vertical
intercept remains unchanged, however.

Exercise 3.7
?
P1 Graphically show the effect of rise and fall in price of X2, with the price of X1 and
money income remaining the same.

The effect of simultaneous change in the prices of the two goods in different proportions can
be shown in the same way as the previous case. In this case, however, both the vertical and
horizontal intercepts change.

In Figure 3.15 below, the initial budget constraint is given by steeper budget line. Given this
initial condition, if the price of X1 rises and the price of X2 falls, the position of the budget

constraint changes. That is, the vertical intercept increases from

M / P2' to M/P2 and the

vertical intercept decreases from

M / P1' to M/P1.

X2
M/P2

M / P2'

'
0 M/P1
M / P1 X1

Figure 3.15: Relative Changes in Price

A proportional change in money income and in the prices of all commodities leaves the
consumer neither better off nor worse off. In relation to rise in income and in the prices of
commodities, the rise in income shifts the budget constraint outward, while the rise in the
prices of commodities shifts the budget line inward, the net effect leaves the budget line at
its original position. In the case of fall in income and commodity prices, the fall in income

102
shifts the budget line in a parallel manner towards the origin, while the fall in the commodity
prices shifts the budget line to the right, the net effect still leaves the budget line unchanged.

3.2.6. The Equilibrium of the Consumer

Dear colleague,we have discussed how an indifference curve and the budget line are
derived. Now, we are going to use these lines in order to determine consumer’s equilibrium.
Let us continue.

The consumer is in equilibrium when he maximizes his utility, given his income and the
commodity prices.The maximization of utility can now be shown by combining a set of
indifference curves with the budget line. For the consumer to maximize his utility two
conditions must be satisfied.

1. The marginal rate of substitution (the slope of indifference curve) must be equal to
the ratio of commodity prices (the slope of budget constraint).

MU x Px
MRS x , y  
MU y Py

This is necessary but not sufficient condition for equilibrium.

2. The indifference curve must be convex to the origin. This condition is satisfied by
the axiom of diminishing marginal rate of substitution, which states that the slope of
the indifference curve declines as we move from left to right.

Given an indifference map and the consumer’s budget constraint, the consumer’s
equilibrium is defined by the tangency of the budget line with the highest possible
indifference curve. As can be seen in the Figure 3.16 below, at point e on indifference curve
II, the budget line and indifference curve II are tangent. Any point on III such as point d, is
preferred to point e, because higher indifference curves represent higher levels of utility.
However, point d is not attainable because it is outside the budget line. Point c on I is
attainable, and point e on indifference curve II also is attainable, and any point on II
represents more satisfaction than any point on I.

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 Y

A d
c

Y* e
III
I II

0 X* B X

Figure 3.16: Consumer’s Equilibrium

The consumer wants to reach the highest attainable indifference curve. The highest
attainable curve is the one which is tangent to the budget line because no higher indifference
curve can be reached with the given income and prices. In Figure 3.16 above, the consumer
maximizes his utility at point e. At the point of tangency (point e), the slope of the budget
line, the ratio of the price of X to the price Y, is equal to the slope of indifference curve II,
marginal rate of substitution.

Px
MRS x , y 
Py

This equality satisfies the first order condition for equilibrium. The second order condition is
also satisfied since the indifference curve is convex at the tangency. Anywhere to the left of
the tangency, MRSx, y is higher than at the tangency; and anywhere to the right of the
tangency, MRSx, y is lower than at the tangency. In Figure 3.16, the consumer maximizes his
utility by consuming X* amount of good X and Y* amount of good Y.

The marginal rate of substitution expresses the willingness of the consumer to trade a certain
amount of X for a certain amount of Y, and the slope of the budget line reflects the market’s
willingness to trade a certain amount of X for a certain amount of Y. The impersonal forces
of the market impose the relative price on the consumer, so the consumer adjusts
consumption amounts in such a way that his tradeoff is the same as that of the market.

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The consumer’s utility maximizing behavior can be generalized to n goods case. With n
goods involved in a consumer’s decision, the equilibrium condition is defined by the
equality of the ratio of marginal utility to price of all commodities.

MU 1 MU 2 MU n
 
P1 P2 Pn

Mathematical derivation of equilibrium:

Assume there are n commodities with pricesP1, P2, …,Pn, and the consumer’s money income
is M. In this case, the problem to the consumer is maximizing his utility subject to his
limited income and market prices. In maximization, the function which represents the
objective that the consumer tries to achieve (in our case utility function) is called the
objective function and the constraint that the consumer faces is represented by the constraint
function (here the budget constraint).

Maximize: U = f (Q1, Q2, …,Qn)

Subject to: M = P1Q1 + P2Q2 + … + PnQn

Rewriting the constraint

M -P1Q1 - P2Q2 - … - PnQn = 0

Multiplying the constraint by Lagrange multiplier 

(M -P1Q1 - P2Q2 - … - PnQn) = 0

Forming a composite function (also called Lagrange function)

 = U +(M -P1Q1 - P2Q2 - … - PnQn)

Since the rewritten constraint function is zero, adding zero to U makes no difference at all.
Now given the composite function which is obtained by combining the objective function
and the constraint function, the process of utility maximization requires that two conditions
be satisfied:

The first order condition requires that the partial derivatives of the Lagrange function with
respect to all quantities and the Langrage multiplier () be zero.

105
  U
  P1 0
Q1 Q1
 U
  P2 0
Q2 Q2

 U
  Pn 0
Qn Qn



 (M -P1Q1 - P2Q2 - … - PnQn)= 0

From these equations, we obtain

U
P1
Q1
U
P2
Q2

U
Pn
Qn

U U U
MU 1 , MU 2 , MU n
Q1 Q2 …,
Q n .

Substituting and solving for , we obtain the equilibrium condition:

MU 1 MU 2 MU n
  ... 
p1 p2 pn .

In a case where there are only two goods, this means

MU x MU y

Px Py
.

Rearranging,

106
 MU x Px
 MRS x , y
MU y Py

The second order condition for maximum requires that the second order partial derivatives
of the Lagrange function with respect to all quantities be negative.

 2  2U
 0
Q12 Q12

 2  2U
 0
Qn2 Qn2

The second order conditions imply that the indifference curves be convex to the origin. It is
necessary that the second order condition be satisfied because for indifference curves with
different shapes, tangency may not necessarily represent equilibrium. Suppose the relevant
indifference curve were linear. In this case, the budget line will lie totally on the indifference
curve, in which case any one point on the indifference curve represents equilibrium. If the
indifference curve were rather concave equilibrium would be defined by corner solution.

Example 3.6

Suppose the utility function of a person consuming two commodities X and Ywith income
0.6 0.4
Birr 600 is given by U 2 X Y . If the per unit price of Xis Birr 20 and per unit price of
Y is Birr 40.
a) Calculate the utility maximizing level of consumption of X1 and X2.
b) Find the MRSX, Y at the optimum.
Solution
The consumer’s objective is the maximization of his utility. Therefore, the utility function is
referred to as an objective function. However, the consumer’s utility maximizing behavior is
constrained by his limited income; accordingly, the budget constraint is referred to as
constraint function.
0.6 0.4
Objective function: U 2 X Y
Constraint function: 20 X  40Y 600

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The consumer’s problem is then;
0.6 0.4
Max U 2 X Y
Subject to 20 X  40Y 600
Rewriting the constraint function
600  20 X  40Y 0
Multiplying the constraint by a Lagrange multiplier
 (600  20 X  40Y ) 0
Forming a composite function

 2 X 0.6Y 0.4   (600  20 X  40Y )

The first order condition for utility maximization requires that all the first order derivatives
of the composite function with respect to X, Y and λ be zero.
First order condition:
 0.4 0.4
 1.2 X Y
1.2 X  0.4Y 0.4  20 0  
X  20 (1)
0 .6  0.6
 0 .8 X Y
0.8 X 0.6Y  0.6  40 0  
Y  40 (2)


600  20 X  40Y 0
 (3)

From equations (1) and (2) we have

1.2 X  0.4Y 0.4 0.8 X 0.6Y  0.6

 
20 40

Rearranging (by cross multiplication)

2.4 X  0.4Y 0.4

1
0.8 X 0.6Y  0.6

3Y  X

Substituting this result in equation (3)

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 600  20(3Y )  40Y 0
60Y 600
Y 6

X 3Y
X 3(6) 18

Second order condition:

 2
2
 0.4(1.2 X (  0.4 1)Y 0.4 )  0.48 X  1.4Y 0.4  0
X

 2
2
 0.6(0.8 X 0.6Y (  0.6 1) )  0.48 X 0.6Y  1.6  0
Y

The second order condition is satisfied, therefore, the consumer should buy 30 units of X and
10 units of Yin order to maximize his utility.

The MRSX, Y at the optimal point is obtained by substituting the optimal quantities of the two
goods in the ratio of marginal utilities that defines MRSX, Y.

MU X
MRS X ,Y 
MU Y

U U
MU X  1.2 X  0.4Y 0.4 MU Y  0.8 X 0.6Y  0.6
X and Y

Y 6
MRS X ,Y 1.5 1.5 0.5
X 18

Exercise 3.8
?
P1 Utility function of a person consuming two commodities X and Ywith income Birr
0.2 0.8
1000 is given by; U 30 X Y . If per unit price of Xis Birr 2 and per unit price of Yis Birr
8,
a) Calculate the utility maximizing level of consumption of X and Y.
b) The MRSX, Yat the utility maximizing position.
c) Find the maximum utility.

109
3.2.6.1. Consumers’ Reaction to Income Changes

Colleague, using an indifference map and the budget line, let’s now trace through the
adjustment process that takes place when a household experiences change in
income.Increase in income leads to a parallel shift of the budget line. With each shift of the
budget line following the rise in income, a new equilibrium position is defined at a higher
position. The new equilibrium represents a higher utility to the consumer, because with
commodity prices remaining the same, the consumer can now buy larger quantity of at least
one of the commodities.By joining the different optimal points associated with different
level of income, we obtain the income-consumption curve.

Definition: income-consumption curve is a curve that shows how the consumption of two
commodities changes as income changes with commodity prices unchanged.
Income
Y Y
Income consumption
M3/Py consumption M3/Pcurve
y

M2/Py curve M2/Py c

M1/Pyc M1/Py
bb
aa

0 M1/Px M2/Px M3/PxX 0 M1/Px M2/Px M3/Px X

(a) (b)

Figure 3.17: Income-Consumption Curve

110
In Figure 3.17, if the consumer’s income is M2, and prices of X
and Y are Px and Py, the optimum utility is at point b. A decrease
in income is represented by M1, and an increase in income is
shown by M3. The respective optimum positions representing
tangencies of a budget line and an indifference curve are points
a andc. If we connect these points, we get what is called an
income-consumption curve. This curve shows how consumption
of two goods changes as income changes.

In panel (b) of Figure 3.17, good Y is a normal good, good X, however, is a normal good for
this person until the individual’s income reaches M2. But when income increases above M2,
less X is bought as income increases. So X is a normal good up to point A, and then becomes
inferior as the income-consumption curve bends backward.

The Engle Curve

The Engle Curve is a curve that relates the equilibrium quantity purchased of a good to the
level of income it corresponds. Joining the different optimal points that correspond to
different levels of income and then relating the optimal quantity of one of the goods under
consideration to the levels of income generates the Engel curve.

Y M
Income-consumption curve
Engel curve
Y3 c M3
Y2 b M2
Y1 a M1

0 X1 X2 X3 X 0 X1 X2 X3X

Figure 3.18: Engel Curve

For each level of income, there will be some optimal choice for each of the goods. If we
keep the prices of the two goods constant (fixed) and focus on what happens to the demand
for good 1 as the level of income changes, we obtain what is known as the Engel Curve.

111
At point a in Figure 3.18, the consumer’s income is M1 and the quantities of X and Y are X1
and Y1. At pointsb and c, the levels of income are M2 and M3 are the respective quantities are
X2 and Y2, and X3 and Y3. By plotting the different quantities of X at different income levels
against their corresponding income, we trace out the Engel curve for X.

The Engel curve presents the demand for one good as a function of income, with prices
remaining constant. It may take different shapes depending on the income elasticity of the
good under consideration.

M M
Engel curve Engel curve
M3 M3
M2M2
M1M1

0 X1 X2 X3 X 0 X1X2X3 X
(a) (b)
Figure 3.19 Income Elasticity and Engel Curves

In panel (a) of Figure 3.19 above, the Engel curve becomes flatter as the consumer’s income
increases, therefore, represents income elastic demand. In panel (b), however, as income
increase, the resulting change in demand becomes lower and lower. Hence, it represents the
case of income inelastic demand.

3.2.6.3. Substitution and Income Effects

We have seen that a change in price of one good, with the price of other goods and money
income remaining the same, results in change in quantity demanded of the good. This effect
on quantity demanded of one good due to change in its price with the price of the other good

112
and income being held constant can be decomposed into substitution effect and income
effect. As a basis to the discussion on substitution and income effects, let’s try to distinguish
between nominal income and real income.

If an individual’s salary in the year 2000 was Birr 1000 and his salary remains the same, say,
up to year 2006, the individual in year 2006 would say “My salary has been constant for five
years.” Is he right? This makes sense only in monetary terms, because Birr 1000 in 2006
cannot buy equal quantity of real goods and services as Birr 1000 in 2000. Therefore, the
individual’s income is constant only in nominal terms. This monetary (nominal) value of
money is what we call nominal income. On the other hand, the quantity of goods and
services that a constant amount of nominal income can buy represents real income. If the
nominal price of one good falls, money income and other nominal prices remaining
constant, real income rises because the consumer can now buy more of the goods (more of
the good whose price declined or more of the other good) . But, if the nominal price of one
good rises, money income and other nominal prices remaining constant, real income falls
because the consumer can now buy less of the goods.

Nominal income – is income measured in Birr; the money value of income.

Real income – is income expressed in terms of the purchasing power of money income; i.e.,
the quantity of goods and services that can be purchased with the money income.

When the price of one good changes, with the price of the other good and nominal income
remaining the same, the consumer moves from one equilibrium position to the other. This
movement of the consumer due to change in price of one good is called the total effect of
price change. This total effect can be divided in to two effects: substitution effect and
income effect. i.e., Total effect = substitution effect + income effect.

First, when the price of a given good falls, the market trade-off between this good and other
goods (or the rate of substitution) changes. This is the substitution effect. Second, the
individual has a larger real income, meaning that with the same money income, more of both
commodities can be purchased. This is the income effect.

Substitution effect: - is the change in consumption of a commodity by a consumer because

of change in the price of that commodity, price of other commodities and real income

113
remaining the same. Income effect, on the other hand, is the change in consumption of a
commodity because of change in real income, commodity prices and money income
assumed constant.

The substitution and income effects of price change are different for different products.

The Normal Goods (Superior Goods) Case

Normal goods are those goods whose quantity demanded is positively related to income. For
a normal good (and for all goods), a decline in price leads to increase in the quantity
demanded of the good.Decline in price of one good, the price of the other good and income
remaining the same, changes the relative prices and makes the good whose price declined
more attractive than the other. Consumers will substitute the relatively expensive good by
the relatively cheap one.

Y
a
a’

Y3 f
Y1 e II
Y2 g
I

0X1 X2 X3 b c’ c X

Figure 3.22 Substitution and Income effects

Colleague, look at the above figure very carefully while discussing the following. For
example, if the price of X in Figure 3.22 above declines from P1 to P2, the budget line pivots
fromab to ac. Though the nominal incomeof the consumer is unchanged, his real income
(purchasing power) has increased because of the declinein price; i.e., he can now buy higher
quantity of X,Y, or both. This would move the equilibrium point frompoint eon indifference
curve I to point fon indifference curve II. This movement represents the total effect of price
change, and it can be segregated into substitution effect and income effect.

114
Increase in the real income of the consumer is shown by the shift to a higher indifference
curve. A higher indifference curve represents a higher level of utility, and utility is a
function of quantities consumed, then the quantities on a higher indifference curve must be
higher than the quantities on a lower indifference curve.To isolate the substitution effect
from income effect, we can consider what would happen if we also reduce the household’s
money income to restore its original purchasing power. To do this, we can reduce money
income until the original bundle of the two goods can just be bought at the new prices. The
consumption bundle that the consumer chooses in this hypothetical situation with the new
prices and the reduced money income reflects the effect of the change in relative prices
when the purchasing power of income is held constant. The resulting change in the
consumer’s choice compared to its initial preferred combination is called the substitution
effect.

The newhypothetical budget line in Figure 3.22 aboveis given by the broken line a’c’. The
substitution effect is, thus, represented by a movement from the original equilibrium
position at e to the hypothetical equilibrium at g. The consumer reduces his consumption of
the relatively expensive good Y by the relatively cheap good X.

In the case of substitution effect, change in relative price makes the consumer move along
the original indifference curve. The income effect, however, moves the consumer from one
indifference curve to the other. To measure the income effect, we restore the consumer’s
income, which shifts the budget line outward, parallel to itself. Since the goods involved are
assumed normal, the consumer increases his consumption of both goods. The change in
quantity demanded of X as a result of the consumer’s reaction to this shift of his budget line
is called income effect.

In Figure 3.22 above, with real income remaining constant, fall in the price of X increased
the quantity demanded of X from X1to X2. This is represented by movement from point e to
point g. Now if we let the consumer’s real income to increase because of the fall in price of
X, the budget line would shift from the hypothetical budget line a’c’ to ac. The movement
from the hypothetical equilibrium g to f represents income effect.

115
Based on the above analyses, we can say that for normal goods, quantity demanded varies
directly with real income and inversely with price.In the case of normal goods, both
substitution effect and income effect are positive.

116
Example 3.7

To understand the substitutions and income effects for a normal good consider the table
below.

Table 3.6: Substitution and Income Effect

P r i c e s C o n s u m p t i o n Total expenditure
Food (F) Clothing (C) Food (F) Clothing (C)
Initial position Birr 12 B i r r 6 1 5 3 0 Birr 360
Price of food falls; cost of initial bundle at new prices Birr 6 B i r r 6 1 5 3 0 Birr 270
Intermediate position Birr 6 B i r r 6 2 1 2 4 Birr 270
F i n a l p o s i t i o n Birr 6 B i r r 6 2 5 3 5 Birr 360

In the initial position, a consumer with income of Birr 360 faces prices of Birr 12 per unit
for food and Birr 6 for clothing, and chooses to purchase 15F and 30C. The money price of
food then falls to Birr 6 per unit. As shown in line 2, the consumer’s initial bundle of 15F
and 30C now costs only Birr 270.

Line 3 shows the consumer’s choice at the new prices when his/her income is reduced to
Birr 270. Although the initial bundle can still be bought at the new prices, the consumer
does not choose to do so. Instead, he increases his consumption of (the now cheaper) food
and reduces his consumption of clothing; he now purchases 21F and 24C.

Line 4 shows what happens when money income is returned to its original level of Birr 360–
the consumption of food and clothing both rise, to 25F and 35C.

Similarly, it is possible to illustrate the effect of increment in price of the commodity. A rise
in the price of the commodity will have effects which are opposite to effects of reduction in
prices.

The Inferior goods case

Colleague, what are inferior goods? Ok. Inferior goods are those goods whose quantity
demanded decreases with rise in income. If now the price of one commodity falls, the price
of the other commodity and income remaining constant, the budget line rotates to the right.
Accordingly, the equilibrium position shifts outward as indicated in the following figure.

117
Y
a
a’
Y3 f
II
Y1 e
Y2 g
I

0 X1 X3X2 b cc X
Figure 3.23 Substitution and Income effects

Suppose the initial budget line is given by line ab. If the price of good X decreases, the
budget line rotates to ac. As the budget line rotates, the equilibrium position shifts form e to
f. This movement constitutes the total effect of price change, and it can be decomposed to
substitution and income effects.

As the price of one product decreases, consumers substitute it for relatively expensive
products. In Figure 3.23 above, substitution effect can be shown by assuming that the
consumer’s income remains the same after the change in price. In order to keep real income
constant, we imagine reduction in the consumer’s nominal income so that the consumer is
able to buy bundles only on his original indifference curve (I). The resulting hypothetical
budget line is ac’. If the price of the other good and income remain the same, the consumer
will move along the original indifference curve from point e to point g. This movement is,
then, called substitution effect.

The income effect of the price change is obtained by restoring the nominal income of the
consumer to its original position. As real income increases, the consumer moves to point f
on a higher indifference curve. The movement from g to f represents income effect. The new
optimal point, however, has less quantity of X, implying that the quantity of X decreases as
the consumer’s income increases. Thus, X must be an inferior good. In this case, the
substitution effect, like the case with normal goods, is positive. Income effect, however, is
negative.

118
Example 3.8

Consider Table 3.7 below to clearly see substitution and income effects of a price change of
an inferior good.

Table 3.7: Substitution and Income Effects of an Inferior Good

P r i c e s C o n s u m p t i o n Total expenditure

Cabbage Meat Cabbage (C) Meat (M)

Initial position B i r r 6 Birr 8 2 0 1 0 Birr 200

Price of cabbage falls; cost of initial bundle at new prices B i r r 4 Birr 8 2 0 1 0 Birr 160

Intermediate position B i r r 4 Birr 8 2 4 8 Birr 160

F i n a l p o s i t i o n B i r r 4 Birr 8 2 2 1 4 Birr 200

Here, it is assumed that cabbage is an inferior good and meat is a normal good. In the initial
position, a consumer with a money income of Birr 200 faces prices of Birr 6 per unit for
cabbage and Birr 8 for a unit of meat, and chooses to purchase 20C and 10M. Then, the price
of cabbage falls to Birr 4 per unit. After the change in price, the initial bundle costs only Birr
160. This is shown in line 2 of the table above. Line 3 shows the consumer’s choice at the
new prices when his/her income is reduced to Birr 160. Although the initial bundle can still
be bought at the new prices, the consumer does not choose to do so. Instead, he increases his
consumption of the cheaper good (cabbage) and reduces his consumption of meat; he now
purchases 22C and 9M. This constitutes substitution effect.

Line 4 shows what happens when money income is returned to its original level of Birr 200–
the consumption of cabbage now decreases to 16 units and consumption of meat increases to
17 units. This represents income effect.

119
Exercise 3.9
? Suppose a consumer buys two goods X and Y. The initial price of X is Birr 3 per unit
P1 that of Y is Birr 4 per unit. The consumer bought 20 units of X and 10 units of Y. The
while
price of X has fallen to Birr 2 per unit with the price of Y unchanged. This change has
resulted in increase in consumption of both X and Y to 21 and 12 units respectively.
a. Show the substitution and income effects in a tabular form as shown in the above
examples.
b. Is the good a normal good or an inferior good?

Generally, in the case of inferior goods, the positive substitution effect of a price change is
great enough to offset a negative income effect and hence total effect becomes positive. But
sometimes, the negative income effect is so strong that it more than offsets the positive
substitution effect. Goods exhibiting these characteristics are called Giffen goods. For these
goods, a decline in price leads to a decline in quantity demanded and a rise in price leads to
a rise in quantity demanded.

UNIT FOUR

120
 THEORY OF PRODUCTION
1. The Short run Production Function

Introduction

In the short run, the firm has relatively short time to adjust the size of its plant in accordance
with developments in the market. The firm’s problem in the short run is finding the best way
of employing existing plant and equipment.

Objectives

At the end of this section, you are expected to:

 Define production function;

 Identify the main features of short run production function;

 Derive average product and marginal product from total product schedule;

 Define the law of diminishing returns; and

 Identify the efficient stage of production in the short run.

4.1.1. The Production Function

Can you define production function? Ok. Look at the following definition.

Definition: A production function shows the technical relationship between factor inputs and
output. It describes the amount of output expected from different combination of input
usage. It can be expressed in tabular or graphic form or by a mathematical formula.

A production function reflects the best technology available for a given level of output in the
production process. Inferior combinations of factors of production (i.e., combinations
involving more of all inputs) to produce the same output are ignored. Suppose a firm uses
labor (L) and capital (K) to produce a given level of output. Let A and B are two different
combinations of factor inputs:-

A B

121
 L 5 4

C 4 4

Both A and B use the same quantity of capital but A uses more labor than B. Then, input
combination A will not be represented on the production function. Only methods that use the
fewest inputs would be captured by the production function.

Factors of production could be fixed or variable. The difference between fixed and variable
factors relates to the time horizon involved. In economics, there are two main horizons; the
short run and the long run. The short run is a relatively short period of time in which the
quantity of some factors of production such as equipments and buildings cannot be varied.
Such factors are called fixed factors. Factors of production whose quantity can be varied in
the short run are called variable factors. The long run, on the other hand, is a relatively long
period which allows the variation of all factors of production including plants and
equipments.

In this section, we will focus on a production process in which there are only two factors of
production; labor and capital, where capital is the fixed factor and labor is the variable
factor.

The production function in this case is defined by

Y  f L K

The bar on K indicates that capital is constant and variation in output depends on variation in
labor L.

Output

Production function

0 Labor
Figure 4.1: Short run Production Function

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As more and more units of a variable factor (L) are combined with fixed factors (in our case
K), we may initially obtain increasingly larger additions to output, but we eventually obtain
smaller increments in output (Look at the above figure). This economic phenomenon is
referred to as the principle of diminishing returns (also called the law of variable
proportions).

Consider, for example, a firm increased the level of labor employed with a unit of capital. At
early stage, since lower level of labor employment does not allow the realization of full
capacity of the machinery, therefore increase in labor employment increases productivity.
Eventually as more and more labor is combined with the single unit of capital, the
machinery will fail to support the large number of workers; therefore the productivity of
labor will fall.

Note, however, that diminishing returns is a short run phenomenon because it is defined
with at least one fixed factor.

Activity 4.1

a) Consider a particular production process (such as farming, construction, etc.) in

your locality and identify the factors of production used.

b) Identify which of the factors used are variable and which are fixed.

Production process: __________________________________________________________

Variable factors of production: _________________________________________________

__________________________________________________________________________

Fixed factors of production: ___________________________________________________

__________________________________________________________________________

4.1.2. Average and Marginal Product Curves

Colleague, can you derive average and marginal product from total product? Just follow
carefully.

Given the production function which transforms a set of inputs into output, the technical
relationship between inputs and output could further be analyzed by deriving marginal and

123
average product curves.

The behavior of total product curve (schedule) has an interesting implication to the marginal
cost and average cost curves (schedules).

Definition: Total product (TP) is the total amount that is produced during a given period of
time. If the inputs of all but one factor are held constant, total product will change as the
quantity of the variable factor used changes.

Suppose capital is fixed at 5 units. By applying varying quantity of labor, the firm can
produce different levels of output (See the figure below).

Table 4.1: Total Product, Average Product and Marginal Product

Qty of capital (K) Qty of Labor (L) Total product (TP) Average product (AP) Marginal product (MP)

5 0 0 - -

5 1 1 5 1 5 . 0 1 5

5 2 3 4 1 7 . 0 1 9

5 3 4 8 1 6 . 0 1 4

5 4 6 0 1 5 . 0 1 2

5 5 6 2 1 2 . 4 2

5 6 6 0 1 0 - 2

Capital being held fixed at 5 units, as the quantity of labor increases, the level of output (TP)
increases. Average product (AP) increases at first and then declines. The same is the true of
marginal product.

Definition: Average product (AP) is the total product divided by the number of units of the
variable factor used to produce it. If we let the number of units of labor be denoted by L, the
average product can be written as

TP
AP 
L

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In Table 4.1 above, as more of the variable factor (labor) is used, AP first rises and then
falls. The level of output at which AP reaches maximum is called the point of diminishing
average productivity. Up to that point, average productivity is increasing; beyond that point,
average productivity is decreasing.

Definition: Marginal Product (MP) – is the change in total product resulting from the use of
one unit more of a variable factor. In the above table, as the first unit of labor is employed,
total product increases by 15 units. This increase in TP is the marginal product of the first
unit of labor. The second unit of labor adds 19 more units of output to TP; therefore, its MP
is 19 units. The fifth unit of labor’s MP is just 2 units of output, while the last unit of labor’s
contribution to output is negative.

dTP
MP 
dL , where dTP is the change in TP, and dL is the change in L.

At initial stages, MP increases as additional variable factors (labor) are employed. Then
reaches maximum and declines. After certain range, it becomes negative with employment
of additional variable factors. The level of output at which, marginal product reaches its
maximum level is called point of diminishing marginal productivity.

Example 4.1

Suppose the production function that a firm faces is given as

2 3
Q  f ( L) K 8 L2  L
3

This production function shows the maximum output that can be produced from various
levels of labor employment, therefore represents TP. The AP is, then, derived as

2 3
8 L2  L
TP 3 8 L  2 L2
AP  
L L 3

Given the AP function, the point of diminishing average productivity occurs where the slope
AP is zero.

dAC 4
8  L 0
The slope of AP = dL 3

125
 4
L 8
3 L 6

Similarly, MP is derived as

2 3
d (8 L2  L)
dTP 3
MP   16 L  2 L2
dL dL

Given the MP function, the point of diminishing marginal productivity occurs where the
slope of MP is zero.

dMP
16  4 L 0
The slope of MP = dL

4 L 16 L 4.

Dear colleague,we have seen how to derive MP and AP functions. Now, let us see the
relationship between these functions, both graphically and algebraically.

4.1.2.1. The Relationship between MP and AP: Graphic approach

The principle of diminishing returns yields an interesting relationship between AP and MP.
Graphically, AP at a particular level of labor employment is given by the slope of a line
from the origin to a point on the TP curve which corresponds to the given level of
employment.

Output
d
cTP

b
a

0 Labor
Figure 4.2: Graphic Derivation of Average Product

126
In Figure 4.2, AP at point a is the slope of a ray from the origin to a; while AP at b is the
slope of a ray from the origin to b. As we move along TP curve from left to right up to point
c, the ray from the origin becomes steeper and steeper. Beyond point c, however, the ray
from the origin becomes flatter and flatter. The steepest possible ray from the origin to any
point on the TP curve is 0c. Therefore, AP reaches maximum at point c.

MP at a particular point on the TP curve is graphically given as the slope of the TP curve at
that particular point. In Figure 4.3 below, MP at point a is the slope of the tangent line at
that particular point. Up to point b, the slope of the tangent line increases as the level of
employment increases. Anywhere to the right of b, the slope of the tangent lines gets flatter
and flatter; and eventually slope is zero at point d. Employment beyond L2 is associated with
less steeper tangent lines. The MP, therefore, reaches its maximum point at b and becomes
zero at point d.

Output
d
c TP

0 L1 L2 L3 L4 Labor

Figure 4.3: Graphic Derivation of Marginal Product

In Figure 4.4 below, the maximum point of the AP is attained at L2 level of employment;
while the maximum point of the MP occurs at a lower level of employment L1. The MP
curve cuts the AP at its maximum point. As long as MP is above AP, AP will continue to
rise. If the contribution of an additional unit of labor is greater than the AP of the previous
units of labor, the new AP will be higher than the previous one. In the contrary, if the
additional output due to employment of one more unit of labor is less than the AP of the
previous units of labor, the new AP will be less than the previous one.

127
To clearly understand this relationship between AP and MP consider, for example, a class of
10 students. Suppose the average height of the students is 170 cm. If now we bring in a tall
student with a height of 192 cm, the average height of the class will increase to 172 cm. This
happens simply because the height of the new student (which we may call the marginal
height) is greater than average height of the class. On the contrary, if we bring in a short
student with height just 159 cm, the average height of the class will fall to 169 cm, because
the height of the new student (marginal height) is less than the average height of the class.
The same relationship holds between AP and MP.

Output
Maximum AP
TP

0 L1 L2 L3 Labor
Output Point of diminishing MP.

Point of diminishing AP.

0 L1 L2 L3 Labor
MP
Figure 4.4: The Relationship between AP and MP

In Figure 4.4, for employment level between 0 and L1 units, TP increases at an increasing
rate (slope of the TP becomes steeper and steeper), this means that MP and AP are also
increasing. At L1, MP reaches its maximum. Between L1 and L2 units of labor, TP increases
at a decreasing rate and MP declines, but is above AP. As a result, AP increases. At L2, AP
reaches maximum and is cut by MP. Between L2 and L3, TP still increases at a decreasing

128
rate, but MP is below AP. This pulls the AP down and AP falls. At L3, MP is zero and TP
reaches maximum. Beyond L3, MP is negative, therefore, TP declines.

Exercise 4.1
?
P1 1 3
Q 5 L2  L
Suppose a firm faces the production function 6 .

a) Derive the AP and MP functions.

b) Determine the point of diminishing average productivity and the point of

diminishing marginal productivity.

4.1.2.2. The Relationship between MP and AP: Algebraic Approach

2
Suppose the production function is given by Q  cL  bL  aL3 .

The marginal product and average product functions are, then defined as

dQ
MP   c  2bL  3aL2
dL , and

Q
AP   c  bL  aL2
L

The maximum point of MP occurs where its slope is zero.

2b  6aL 0

b
L
3a

The maximum point of AP, on the other hand, occurs where its slope is zero.

b  2aL 0

b
L
2a

b b

Since 3a 2a , the maximum point of MP lies to the left of the maximum point of AP.

129
Let’s now try to show that MP cuts AP at its maximum point. If this is true, the point of
intersection of MP and AP must coincide with the maximum point of AP.

At the point of intersection MP  AP . This means:

 c  2bL  3aL2  c  bL  aL2

3aL2  aL2  bL  2bL 0

2aL2  bL 0

L(2aL  b) 0

L 0 or 2aL b

b
L 0 or L 
2a

Q  f ( L) K
With the production function defined as , however, we are interested with
b
L
positive level of labor employment. Therefore, 2a .

The result verifies that MP cuts AP at its maximum point.

Example 4.2

Consider the production function in example 4.1. The MP and AP functions were found to
2 2
2
AP 8 L  L
be MP 16 L  2 L and 3 .

In the example 4.1, it was found that the maximum point of AP occurs at L = 6.

At the point of intersection of AP and MP

2 2
8L  L 16 L  2 L2
3

2 2
2 L2  L  16 L  8 L 0
3

4 2
L  8 L 0
3

130
 4
L( L  8) 0
3

L 0 or L 6

Since output varies with variation in L, we are interested with positive level of labor
employment. Therefore, MP crosses AP at L = 6.

For employment level less than L = 6, MP is greater than AP, therefore AP will rise.
Consider for example L = 5.

At L = 5,
MP 16(5)  2(5) 2

MP 30

2
AP 8(5)  (5) 2 23.33
3

For employment level greater than L = 6, MP is less than AP, therefore AP will fall. For
example consider L = 7.

At L = 7,
MP 16(7)  2(7) 2

MP 14
2
AP 8(7)  (7) 2 23.33
3

Exercise 4.2
?
P1 2
Suppose a firm faces the production function Q 4 L  12 L  2 L3 .

a) Find the maximum points of MP and AP curves.

b) Show that MP crosses AP at its maximum point.

4.1.3. The Stages of Production

Colleague, now, we are going to discuss the different stages of production. The marginal
product of a factor may assume a positive, zero or a negative value. However, basic
production theory concentrates only on the efficient part of the production function, that is,

131
on the range of output over which the marginal product of a factor (labor in our case) is
positive. No rational firm would employ labor beyond B as in Figure 4.5, since the increase
in labor beyond this level would result in reduction of total output (MP is negative). Ranges
of output over which marginal product of a factor is negative imply irrational behavior.

We may split the whole production functions into three segments (or stages). Stage I
represents a range over which output grows at an increasing rate causing the MP to rise,
therefore, there is no rationale for a firm to stop its employment over this range because an
additional unit of labor produces more than the previous units. Stage III is one on which
output decreases, implying that employment of additional units reduces output, i.e. MP is
negative.

TP

Q = f(L)
Stage I Stage II Stage III

0 A B L
MP

Stage I Stage II Stage III

0 A B L
MPL
Figure 4.5: Stages of Production

The basic theory of production usually concentrates on the range of output over which the
MP of a variable factor (labor) decreases, but is positive; i.e., the range of diminishing (but

132
non- negative) productivity of the factor. This range of production is given by AB, which
defines Stage II.

Formally, the efficient stage of production is defined by the condition:

Q
MPL  0
L MP of labor should be positive.

MPL  2Q
 2
L L < 0  the slope of MP should be negative.

Exercise 4.3
?
P1 For the production function in Exercise 4.2, find the range of labor employment for
stage I, stage II and stage III.

Section 2: The Long run Production Function

Introduction

Dear learner,we have seen the short run production function in the previous section. In this
section, we will emphasis on the long run production function. Let us continue.

In the long run, all factors of production are variable. Firms, therefore, can alter their output
by varying all factors. The problem to the firm is finding the most efficient way of
producing output.

At its simplest case with just two factors involved, the production function of a firm is
defined by a set of isoquants each of which representing certain level of output. The
acquisition of factors of production, however, involves costs. The cost constraint that the
firm faces is given by isocost lines. The firm determines its equilibrium by combining
isoquants and isocost lines.

Note that the discussion in this section could also be applied in the short run assuming all
factors are variable.

Objectives

At the end of this section, you should be able to:

133
  Define the long run production function;

 Identify the major differences between the short run production function and the long
run production function;

 Define isocost lines, isoclines and isorevenue lines;

 Define the laws of returns to scale;

 Determine cost minimizing (profit maximizing) factor combination of a firm in the

long run;

 Define and derive the short run expansion path; and

 Define and derive the long run expansion path.

4.2.1. The Production Function

Suppose that a production process involves just two factors labor (L) and capital (K). In this
case the production function is defined as:

Q  f ( L, K )

Colleague, the production function we saw under section 4.1 was drawn on the assumption
that all other factors of production except labor are fixed. However, with two variable
factors L and K, the relevant production function is defined by a set of isoquants.

An isoquant is the locus of all technically efficient methods (all combinations of factors of
production) for producing a given level of output; i.e. it shows the different combinations of
L and K that can be used to produce a given level of output. The production isoquant may
assume various shapes depending on the degree of substitutability of factors.

Linear Isoquant- assumes perfect substitutability of factors of production: a given

commodity may be produced using only capital, or only labor, or by an infinite combination
of K and L. This isoquant implicitly assumes that factors are perfectly divisible (See the
figure below).

134
 Isoquant

0 L
Figure 4.7: Linear Isoquant.

The assumption of perfect divisibility is, however, unrealistic. Most factors of production
are not perfectly divisible. Tractor cannot be, for example, considered divisible. There is no
such thing as 0.5 unit of tractor, 0.21 unit of tractor, etc.

Input-output Isoquant- assumes strict complementarily (zero substitutability) between

factors of production. There is only one efficient method of production for any given level
of output, which is defined at the corner of the L-shaped isoquant. Though, operation
anywhere on the vertical as well as the horizontal segments is possible, it involves larger
quantity of one of the factors and not less of the other. This implies, therefore, irrational
behavior.

Isoquant

0 L
Figure 4.8: Input-Output Isoquant.

Along the vertical segment of the input-output isoquant (Figure 4.8 above), a firm uses more
and more of capital but not less of labor to produce the same level of output. Along the
horizontal segment, on the other hand, the firm uses more and more units of labor but not
less of capital. It is not rational, therefore, for a firm to operate along the vertical or
horizontal segments of the L-shaped isoquant.

Kinked Isoquant- assumes limited substitutability between factors of production L and K.

There are a few processes for producing any one commodity. Substitutability of factors is
possible only at the kinks. This isoquant assumes that factors are not perfectly divisible.

135
Among the four widely known types of isoquants this one is the most realistic. In the real
world, factors substitute each other only to a limited extent.

136
 P1
K P2
K1
K2 P3
K3 Isoquant

0 L1 L2 L3 L
Figure 4.9: Kinked Isoquant

In Figure 4.9 above, factor combinations (L1, K1) and (L2, K2) yield the same level of output
since both are located on the same isoquant. This implies the effect of fall in capital from K1
to K2 could be offset by rise in labor from L1 to L2. Substitution between these two points is,
however, impossible. This point is in harmony with the fact that some factors are not
perfectly divisible. Continuous substitution of inputs requires that the factors involved be
perfectly divisible.

Smooth, Convex Isoquant – assumes continuous substitutability of K and L only over a

certain range, beyond which factors cannot substitute each other. The isoquant appears as a
smooth curve convex to the origin. Substitution of one factor by the other is possible only on
the convex segment of the isoquant. The smooth, convex isoquant is a limiting case of the
kinked isoquant with infinite number of kinks. Traditional theory of production mostly
adopted the continuous isoquants because; they are mathematically simple to handle by
simple rules of calculus.

Isoquant

0 L
Figure 4.10: Smooth, Convex Isoquant.

137
Activity 4.2

Consider a particular production process in your locality and identify which of the different
types of isoquants discussed above better explains the degree of substitutability of factors.
Why?

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

4.2.2. Characteristics of Isoquants

 Given a set of isoquants, the higher to the right an isoquant, the higher the
level of output it represents. Conversely, the lower an isoquant the lower the level of output
it represents. This is because higher isoquants are associated with higher quantity of factors
while lower isoquants are associated with lower quantity of factors.

 Isoquants do not intersect each other. The point at which two isoquants cross
each other implies two different levels of output, which is not possible.

K
a d

b
c I
e II
0 L
Figure 4.11: Non-intersection of Isoquants

In Figure 4.11, isoquants I and II cross each other at point b. Points a, b and c are located on
the same isoquant, therefore, represent the same level of output. Similarly points d, b and e
are located on the same isoquant, therefore represent the same level of output. Point d is,
however, located to the right of point a; and must represent a higher level of output. By rule

138
of transitivity, since d represents higher level of output than a and the same level of output
as b, therefore, b must represent higher level of output than a. Yet, this is not true.

4.2.3. The Efficient Stage of Production

Dear learner, how do you think is the efficient stage of production be determined using
isoquants? Ok. Don’t worry, we will see it together.

A production function shows the different levels of output that can be produced using
different combinations of inputs. Hence, it is defined by a set of isoquants each of which
representing a different level of output. It shows how output varies as the factor inputs
change.

K1 a
K2 b Q1
K3 c Q2
Q3
0 L1 L2 L3 L
Figure 4.12: Long run Production Function

Each of the three isoquants in Figure 4.12 above represents distinct level of output with Q1
greater than Q2 which in turn is greater than Q3.

Colleague, do you remember what we have said while discussing short-run production
function? We have said that the general theory of production concentrates on ranges over
which marginal product of factors is positive but decreasing. With two variable factors
involved in the production process, the efficient stage of production is that the marginal
product of labor and the marginal product of capital are both positive but decreasing.

Mathematically:

Q Q
L = MPL> 0 and K = MPK> 0

139
  2 Q MPL
2

Slope of MPL=  L L < 0 and

 2 Q MPK
2

Slope of MPK = K K < 0

Consider isoquant Q2in Figure 4.12 above. At point a, the firm uses L1 labor and K1 capital
to produce Q2output. At point b, the firm uses more labor and less capital to produce the
same amount of output. At point c, the amount of labor required to produce Q2further
increases while the amount of capital decreases.

As we move along an isoquant from left to right, the quantity of labor increases while that of
capital decreases; implying increase in productivity of capital and decrease in the
productivity of labor. Eventually, the marginal productivity of labor becomes zero. As we
move from right, in order to produce the same level of output, the firm uses more and more
units of capital and less and less units of labor. This implies that the productivity of labor
increases and that of capital decreases. Eventually the marginal productivity of capital
becomes zero.

Figure 4.13 below shows the efficient range of production with a production function
involving two variable inputs (labor and capital). For various levels of output, joining the
points at which the marginal product of labor and the marginal product of capital are zero
yields what are called ridge lines. Along a ridge line either the marginal product of labor or
marginal product of capital is zero.

K
Upper ridge line

Lower ridge line

Q3
Q2
Q1

1 L
Figure 4.13: Efficient Stage of Production.

140
The upper ridge line is formed by joining points on successive isoquants at which MPK is
zero. Similarly, the lower ridge line is formed by joining points on successive isoquants at
which MPL is zero.

Efficient production techniques are those inside the ridge lines. Outside the ridge lines MP
of factors is negative implying that techniques of production in this region are inefficient
since they involve more of at least one factor but not less of the other. The condition of
positive but declining marginal products of the factors defines the range of efficient
production (the range in which isoquants are convex to the origin).

4.2.4. Substitution of Inputs

Colleague, let us, now, turn to the discussion of substitutability between two factors. Along
a convex isoquant, a firm has to increase the quantity of one factor of production (L) for any
fall in the quantity of the other factor (K) in order to produce the same level of output.

  dK 
 
The slope of an isoquant  dL  could be defined to show the degree of substitutability of
factors of production. It declines in absolute value as we move from left to right along an
isoquant. The slope of an isoquant is called Marginal Rate of Technical Substitution of labor
for capital (MRTSL,K).

 dK MPL
MRTSL,K = dL = MPK

Proof :

Suppose the production function is given as Q = f (L,K).

Q Q
dL dK
dQ = L + K

Along an isoquant output is constant (dQ = 0)

Q Q
dL  dK 0
L K

Q Q
dL  dK
L K

141
 Q Q
MPL MPK
But L and K

MPL dL  MPK dK

dK MPL
  MRTS L , K
dL MPK

As we have seen above, the MPL decreases while MPKincreases as we move from left to
MPL
right along a convex isoquant. This causes fall in slope of the isoquant MPK .

MRTSL,K measures the quantity of capital that must be given up in order to increase the
quantity of labor by one unit, so that output remains the same. In Figure 4.12 above, the
movement from point a to point b involves relatively lower increase in labor (from L1roL2)
for a given fall in capital (from K1 to K2). But if capital further decreases by an equal amount
(from K2 to K3), labor increases by higher magnitude (from L2 to L3) to keep output at a
constant level. This implies, therefore, the amount of capital sacrificed for a unit of labor
decreases as we move from left to right along an isoquant.

The substitutability of factors could be considered in relation to the ridge lines. Along the
lower ridge line MPL 0 and MPK is positive. Therefore,

MPL 0

MRTSL,K = MPK MPK = 0

Since the productivity of labor is zero along the lower ridge line, there is no substitution
between L and K.

Along the upper ridge line MPK 0 and MPL is positive. Therefore,

MPK 0
 0
MRTSK,L = MPL MP L

Similarly, with MPK zero along the upper ridge line, L cannot be substituted by K and vice
versa. Substitution of one factor for the other is possible only between the ridge lines.

142
In order to understand how MRTSL, K is measured and interpreted, consider the following
example.

Example 4.3

Suppose the production function that a firm faces is given as Q 2 L  4 K .

dQ dQ
MPL  2 MPK  4
dL , and dK

MPL
MRTS L , K  1 / 2
MPK .

This result implies that for a unit rise/fall in labor, capital falls/rises by ½ units.

Dear learner, the marginal rate of technical substitution (MRTSL,K) as a measure of degree of
technical substitutability of factors has a serous limitation. It depends on the units of
measurement of factors. Suppose labor is measured in wage hours and capital is measured in
Birr. Further assume that MPL is 10 units per wage hour and MPK is 5 units per Birr.

10 per wage hour

MRTS L , K  2 wage hour/Birr
5 per Birr

Since MRTSL, K is not a unit free measure of substitution, it becomes impossible to compare
MRTSL, K across firms, industries, or over time if the units of measurement are not uniform.
In other words, comparison would be impossible if, for example, one firm measures
MRTS L , K
in terms of wage hour per Birr and another firm uses number of workers per
capital hour etc.

A better measure of factor substitution is provided by the elasticity of substitution.

Percentage change in K/L ratio


Percenage change in MRTS L, K

d ( K / L) /( K / L)

d ( MRTS L , K ) /( MRTS L , K )

The elasticity of substation (  ) is a pure number independent of the units of measurement

of L and K, since both the numerator and the denominator are measured in the same units.

143
Example 4.4

Given a Cobb – Douglas production function

Q  0 L1 K  2
,

it can be shown that elasticity of substitution is unity.

Q
MPL   0 1 L1  1 K  2
L

1
1 L
1 . . 0 L1 K  2 L1  1 
L ; because L

 
But
 0 L K Q
1 2

Q
1
MPL = L

Q
K   L1 K  2  1
MPK = = 2 0

2
1 K
 2 .  0 L1 K  2 K 2  1 
K ; because K

 
But
 0 L K
1
Q 2

Q
MPK  2
K

MPL 1 .(Q / L) 1 K
  .
MRTSL, K=
MPK  2 .(Q / K ) 2 L

d ( K / L) /( K / L)

d ( MRTS L , K ) /( MRTS L , K )

d ( K / L) /( K / L)

 K  K
d ( 1 . ) /( 1 . )
 2 L 2 L

 1

144
The elasticity of substitution of a Cobb-Douglas production function is always 1. This
implies that for a one percent change in MRTSL, K, the factor proportion (K/L) changes by one
percent. If both L and K are assumed normal goods, the sign of  will be negative. This is so
because MRTSL, K rises if MPL rises by a higher percentage than MPK, which induces increase
in employment of L by a higher percentage than K.

? Exercise 4.4
P1
0.5 0.5
Suppose a production function is given as
Q 4 L K .

a) Find the MRTSL, K.

b) Find the elasticity of substitution.

4.2.5. Laws of Returns to Scale

Dear colleague,here, we are going to discuss another important concept, returns to scale,
which is a long run phenomenon.

Laws of returns to scale relate to long-run analysis of production. In the long-run, output
could be expanded by varying all factors of production because in the long run all factors are
variable. Factors could be varied in the same proportion (all factors are simultaneously
increased or decreased by the same percentage) or in different proportions. The traditional
theory of production deals with the former case.

Definition: Returns to scale measure the responsiveness of output as all factors are increased
by the same proportion. Suppose the initial level of inputs and the corresponding output are
given by

Q0 = f (L, K)

If now both inputs L and K are increased by the proportion c, the level of output will
increase to Q1. The new level of output is given as

Q1 = f (cL, cK)

145
  If Q increases by the proportion c as both L and K are increased by the proportion c,
we say the production function exhibits constant returns to scale.

 If Q increases by a proportion greater than c as both L and K are increased by the

proportion c, we say the production function exhibits increasing returns to scale.

 If, on the other hand, increase by the proportion c of both L&K causes a less than
proportionate increase in Q, we say the production function exhibits decreasing
returns to scale.

4.2.5.1. Homogeneous functions

Homogeneity of production functions have interesting implication to the returns to scale

implied by the production functions.

Given a production function

Q0 = f (L , K)

If both inputs are increased by the proportion c and the function can be rewritten in the form

Q1 = f (cL, cK) = cV(L, K)

The function is called a homogeneous function.

Definition: A homogeneous function is a function such that if each of the inputs is multiplied
by c, then c can be completely factored out of the function. The power v of c is called the
degree of homogeneity of the function and is a measure of the returns to scale. It shows by
what percentage output responds to a given percentage increase in both factors.

 If v = 1  constant returns to scale.

 If v> 1  increasing returns to scale.

 If v< 1  decreasing returns to scale.

If, however, c cannot be factored out of the function, the function will be non-homogeneous.

Example 4.5

In order to understand the relationship between homogeneity and returns to scale consider
the following equations.

146
Suppose a production function is defined as Q LK . If the quantity of both L and K is
increased by a proportion c, the new level of output will be

Q  (cL) (cK )

Q c 2 LK

But Q = LK.

Q c 2Q

Since the exponent (power) of c is 2, this function is said to be homogenous of degree two.

This result implies that an increase in L and K by a proportion c increases output two fold.
To put it differently, since v >1, the production function exhibits increasing returns to scale.

Suppose the production function is, rather, defined as Q 2 L  4 K . If both L and K are
increased by c, the new level of output will be

Q  2cL  4cK

Q  c (2 L  4 K )

But Q = 2L + 4K

Q  cQ

In this case since v = 1, the function, therefore, is linearly homogenous. This indicates that
the production function reveals constant returns to scale, i.e. output increases by c as both L
and K are increased by c.

L
Q
Now, suppose the production function is given as K . Rise in both L and K by c leaves
the level of output at

cL
Q 
cK

cL
Q  0.5
c K

147
 L
Q c 0.5
K

L
Q
But K

Q c 0.5Q

Since v < 1, the production function exhibits decreasing returns to scale.

Activity 4.3

Consider the production process you have identified in activity 1 or 2. How do you think
output will respond if the quantity of all factors used is doubled? Why?

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

In relation to returns to scale, Cobb-Douglas production function has an interesting feature.

Consider the Cobb – Douglas production function below

Q = L 1 K 2
 

Where, α, 1 and 2 are all positive constants.

It can be shown that the returns to scale implied by the function is measured by the sum of
the exponents of the factors used in production (  1 +  2).

Proof:

Q L1 K  2

If both L and K are increased by c Q   (cL) 1 (cK )  2

c 1 L1 c  2 K  2
c ( 1  2 )L1 K  2

But
Q L1 K  2

148
 Q c ( 1  2 ) Q

 v = (1+ 2)

The returns to scale implied by a Cobb-Douglas production function is, therefore, the sum of
the exponents of factors used in production.

4.2.6. Isocost Lines

In order to show the production decision of a firm we need to see the constraint that the firm
faces. This constraint is given by isocost lines.

If the production function of a firm is defined as Q = f (L, K),the total cost of the firm
consists of cost on labor and capital. This cost is summarized by the isocost line.

Definition: an Isocost line is a locus of all combination of factors a firm can purchase with a
given monetary outlay. It is given by the cost equation

C wL  rK

Where,w is price of labor (wages) and r is price of capital (interest rate). The bar over C
indicates constant level of cost.

Isocost lines have the feature that cost of production is constant along an isocost line and
that a higher isocost line represents a higher cost condition than a lower isocost line.

The equation of the isocost line is obtained by solving for K.

C w
 L
K= r r

The slope of the isocost line is the ratio of the prices of labor and capital.

dK w

Slope of isocost line is dL r

K
C /r

Isocost line

149
0 C /w L
Figure 4.15: Isocost Line

4.2.7. Equilibrium of the Firm

The firm’s objective is the maximization of its profit, which is defined as the difference
between revenue and costs, for given factor prices and price of the product.

Definition: a firm is said to be at equilibrium when it maximizes its profit.

Max  = R –C, where  is profit, R is total revenue, and C is total cost.

To maximize its profit, a firm can adopt two approaches;

 Maximizing output for a given cost, factor prices and price of the product −
this involves determining the best combination of L and K. which enables the firm achieve
the highest possible output for any constant level of monetary outlay.

 Minimizing cost for a given output and output price − this one involves
finding the L and K combination which costs the firm the least for any constant level of
output.

Let us see each approach one by one as follows:

4.2.7.1. Maximization of Output Subject to Cost Constraint

In this case, the equilibrium of the firm is defined at the tangency of the isocost curve with
the highest possible isoquant. For any given cost condition represented by the isocost curve,
the highest attainable level of output is the one represented by the isoquant tangent to the
isocost curve.

The optimal combination of the two factors L&K is, consequently, given by L* and K* in
Figure 4.16 below. Other points along the isocost line such as a andb lie below isoquant II
and hence correspond to lower levels of output. Operation on isoquant III is desirable but is
not attainable. Thus, given isocostAB, the optimal level of output is reached at point e.

150
K
A
a
K* e III
II
b I
0 L* B L
Figure 4.16: Equilibrium of the Firm: Output Maximization.
w
At point e, the slope of the isoquant (MRTSL, K) is equal to the slope of the isocost line ( r ).
This constitutes the first condition for equilibrium. The second condition requires that the
isoquant be convex to the origin. If the isoquant is concave, for example, the point of
tangency will not represent equilibrium.

K1
K* e

0 L*L1 L
Figure 4.17: Equilibrium with Concave Isoquant

Figure 4.17 shows what equilibrium would look like if the isoquant were concave. The point
of tangency e does not represent equilibrium of the firm; because the firm can produce the
same level of output at a lower cost by operating either at the vertical intercept of the
isoquant (with K1 capital and no labor) or at the horizontal intercept of the isoquant (with no
capital and L1 labor). We have a corner solution in this case.

Formal derivation of the equilibrium

Maximize Q = f (L, K)

Subject to C wL  rK

151
The bar over C represents that the level of monetary outlay is constant.

Rewriting the constraint using a Lagrange multiplier  gives

 (C  wL  rK ) 0 ; Since C  wL  rK 0

Here the firm maximizes its output for a given cost constraint, by differentiating the
Lagrange function  with respect to L, K and the Lagrange multiplier .

 Q   (C  wL  rK )
First order condition:

 Q
    w 0
L L

Q MPL
w   
 L w

 Q
    r  0
K K

Q MPK
 r   
K r


C  wL  rk 0  C wL  rK


At equilibrium of the firm,

MPL MPK MPL w

  
= w r MPK r

Second order condition:

 2  2 Q  2  2 Q
 0  2 0
L2 L2 and K
2
K

This second order condition implies that the MPL and the MPK be decreasing, which is the
case in stage II.

At equilibrium, therefore, the slope of the isoquant must be equal to the slope of the isocost
curve. Furthermore, the isoquant must be convex to the origin.

152
Example 4.6

0.7 0.3
Suppose the production function of a firm is
Q 20 L K . If the maximum production
expenditure is Birr 600, wage rate (w) is Birr 20 and interest rate (r) is Birr 30, find the
profit maximizing level of labor and capital employment.

The cost constraint that the firm faces is 600 20 L  30 K

MPL w

The first order condition for equilibrium is MPK r

Q Q
MPL  14 L 0.3 K 0.3 MPK  6 L0.7 K  0.7
L and K

MPL 14 L 0.3 K 0.3 7 K

 0.7  0.7 
MPK 6L K 3L

Therefore, at equilibrium

7 K 20

3L 30

20 3L
K 
30 7

2
K L
7

Substituting this into the constraint function

2
600 20 L  30( L)
7

2
K  (21) 6
L 21 7

 2Q  2Q
2
 0 and  0.
The second order condition for equilibrium requires that L K 2

 2Q
2
 4.2 L 1.3 K 0.3  0
L for all positive L and K.

153
 0.14

 2Q
2
 4.2 L0.7 K  1.7  0
K for all positive L and K.

 1.68

Since the second order condition is satisfied, the firm will maximize its profit by employing
21 units of labor and 6 units of capital.

Exercise 4.6
?
P1 Suppose the production function of a firm that uses two factors L and Kis

Q 4 L0.5 K 0.5 . The firm plans to spend Birr 100 on production. If wage rate (w) is Birr 5 and
interest rate (r) is Birr 10, find the profit maximizing L and K combination.

4.2.7.2. Cost Minimization for a Given Level of Output

Colleague, like the case with output maximization, the equilibrium of the firm in the case of
cost minimization is defined by the tangency of an isoquant with an isocost line.

The firm wants to produce a given level of output with the least possible cost. Thus, we have
a single isoquant representing a given output level and a set of isocosts each denoting
different cost condition. These isocosts are parallel to one another (have the same slope)
because they are drawn on the assumption of a given factor prices.

The least cost combination of L and K is defined at the tangency e of Figure 4.18. Cost
conditions below e are preferred by a rational producer, but they are not compatible with
output level Q1. Points above e, on the other hand, represent higher cost conditions,
therefore, are not preferred. The least cost combination of factors is defined at point e with
K* amount of capital and L* amount of labor.

154
 K

K* e
Q1

0 L* L
Figure 4.18: Equilibrium of the Firm: Cost Minimization.

Formal Derivation of Equilibrium

The problem that the firm faces in this case is given as

Minimize C = wL + rK

Subject to Q = f(L, K)

Rewriting the constraint, we have  (Q  f ( L, K )) 0 .

 C   (Q  f ( L, K ))

 wL  rK   (Q  f ( L, K )

First order condition:

 f ( L, K ) Q
w  0
L = L = 0; (because Q is a constant and L )

f ( L, K )
w 
 L

 f ( L, K ) Q
r   0 0
K K ; (because Q is a constant and K )

f ( L, K )
 r 
K


Q  f ( L, K ) 0


 Q  f ( L, K )

155
 f ( L, K )

w  L MPL

MPL

 w

f ( L, K )
r  K =  MPK

MPK
 = r

At the firm’s equilibrium

MPL MPK
MPL w

w r  MPK = r

This equilibrium condition implies that the ratio of the MP of labor and capital (slope of the
isoquant) must be equal to the ratio of prices of factors L and K (slope of the isocost line).

Second order condition:

 2  2 f ( L, K )  2 f ( L, K )  2 Q
  2 0
L2 = L2 >0  L2 L

 2  2 f ( L, K )  2 f ( L, K )  2 Q
    2 0
K 2 k 2 >0  K 2 K

Example 4.7
4
0.4 0.6
A production function is given as Q  f ( L, K ) 3 L K . The price of labor (w) is Birr 20
10

per unit and the price of capital (r) is Birr 10 per unit. Find the cost minimizing quantities of
labor and capital for producing 30 units of output.
4
0.4 0.6
The constraint function that the firm faces is 30 310 L K .
MPL w

The first order condition for equilibrium is
MPK r.
4 4
Q Q
MPL  0.4(310 L 0.6 K 0.6 ) and MPK  0.6(310 L0.4 K  0.4 )
L L

156
 4
MPL 0.4(3 L 0.6 K 0.6 ) 2 K
10
 4

MPK 10 0.4  0.4 3L
Therefore, 0.6(3 L K )

Therefore, at equilibrium
2 K 20

3L 10
K 3L
Substituting this in the constraint function,
4
30 3 L0.4 (3L) 0.6
10

30 3L
L 10 K 3(10) 30

 2Q  2Q
2
 0 and 0
The second order condition for cost minimization requires that L K 2 .
4
 2Q
2
 0.24(310 L 1.6 K 0.6 )  0
L for all positive L and K.
 0.072
4
 2Q
2
 0.24(310 L0.4 K  1.4 )  0
K for all positive L and K.
 0.008
Since the second order condition is satisfied, the firm will minimize its cost at employment
level 10 units of labor and 30 units of capital.

Exercise 4.7
?
P1 0.2 0.7
L K 0.8 . Wage rate (w) is Birr 42
Suppose a firm’s production function is Q 16
and interest rate (r) is Birr 3. Find the cost minimizing L and K combination if the firm
wishes to produce 128 units of output.

4.2.8. The Expansion Path

4.2.8.1. The Short run Expansion Path

Now, let us look at another concept: expansion path.

157
Definition: the expansion path is the path that output follows over time, and shows the
alternatives open to the firm as defined by the production function.

In the short run, output is expanded by varying the quantity only of the variable factor(s) of
production.

Given a production function Q = f(L, K ), in the short run capital is fixed and the firm is
forced to expand its output along a straight line parallel to the axis on which the variable
factor labor is measured.

Ka b c Short run expansion path

Q2 Q3
Q1

0 L1 L2L3 L4 L
Figure 4.6: Short run Expansion Path.

If both factors were variable, the optimal path for expanding output would be 0A, which
shows the equilibrium combinations of L and K for producing different levels of output.
With capital constant, however, the firm expands its output by increasing the quantity of
labor used in production.

In Figure 4.6, the equilibrium point for producing Q1 is defined at a where the firm uses K
capital and L1 labor. The equilibrium quantity of labor required to produce Q2 would be L2 if
capital were variable. But, with capital constant at K , the firm will be forced to operate at
point b using L3 amount of labor. Compared to the point of tangency at which the firm
maximizes its profit, point b corresponds to a higher cost condition. Similarly, the firm can
only produce Q3 using L4 of labor at point c, with capital constant at K . Yet, c is not a profit
maximizing position. The implication is, therefore, that the firm will not maximize its profit
by expanding its output along the horizontal short run expansion path.

158
 Exercise 4.8
?
P1 Derive the short run expansion path of a firm if the production function is given as
Q  f ( L, K ) assuming capital is the variable factor of production and labor is the fixed

factor of production.

4.2.8.2. The Long run Expansion Path

Dear learner,we have said that all factors of production are variable in the long run. There is
no limit to the expansion of output imposed by fixed factors. The firm’s problem is the
choice of the optimal way of expanding output so as to maximize its profit. For a given
factor price ratio, the long run expansion path is obtained by joining the tangencies of
successive isoquants and isocost lines.The long run expansion path will be a straight line if
the production function is homogeneous.

With factor price ratio w/r and given production function, the optimal expansion path is
defined by the locus of points of tangency of the isoquants with successive parallel isocost
lines whose slope is w/r, line 0A in Figure 4.19 below.

K
A
w
r
B

w
r
0 L
Figure 4.19: Long run Expansion Path.

If now the factor price ratio changes to w/ r  , the tangencies of the new set of isocost lines
and isoquants yield long run expansion path 0B. The K/L ratio for producing a given level of
output is higher along expansion path 0A than expansion path 0B.

159
The factor price ratio w/r determines the tangencies of successive isoquants and isocost
lines, which in turn determine the slope to the expansion path. The slope of the expansion
path shows the optimal K/L ratio.

K/L ratio is a measure of factor intensity. A technology is said to be labor intensive if it uses
more labor than capital in the production process, i.e. K/L ratio is low. If a technology uses
more capital than labor in production, i.e. if K/L ratio is high, it is called capital intensive.

Activity 4.4

Suppose in Ethiopian economy the major factors of production are labor and capital. If you
are asked by the government for an advice on the type of technology to be adopted in
expanding the economy over longer time horizon, what would be the type of expansion path
that you propose? Discuss in relation to the country’s resource endowment. (Hint: The long
run expansion path could be labor intensive or capital intensive.)
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

4.2.9. The Multi-Product firm

Dear colleague, up to now, we have discussed the conditions of a firm producing a single
product. But, we may also have cases in which firms are involved in the production of two
or more commodities. Let us continue with this situation.

4.2.9.1. The Production Function

A multi-plant firm is a firm that produces two or more products. For simplicity, suppose a
firm produces two products, X and Y using two factors of production L and K, each with
production functions defined as:

X = f(L, K)and

Y = g(L, K).

With several products involved, the production function of the firm is defined by a
production possibility curve (PPC). Here X is the good of our interest and Y represents all

160
other goods. The production function, thus, shows the production trade off between good X
and all other goods (Y).

Definition: The production possibility curve shows the different combinations of the two
goods that the firm can produce if the available factors are fully utilized, i.e. it shows the
quantities of X and Y than can be produced if L and K are fully employed.

The PPC is derived from Edgeworth’s contract curve. For the derivation of the PPC,
suppose the firm has 0L amount of labor and 0K amount of capital, which it may allocate
between the production of X and Y.

Edgeworth’s box diagram below presents the production function of each product on the
same plane. The set of isoquants convex to the 0x axis represents the production function for
X while the isoquants convex to the 0y axis represent the production function for Y.

Ly 0y
K
Edgeworth’s Contract
Y1 Curve
Y2 X5
KxY3 N X4Ky
b
Y4a X3
Y5 X2
X1
0x Lx L
Figure 4.20: Edgeworth’s Box Diagram.

Any point in Edgeworth’s box represents a given combination of goods X and Y when all the
available resources (L and K) are fully utilized. For a given quantity of the two factors labor
and capital, the efficient combinations of the two products are defined by Edgeworth’s
contract curve.

Definition: Edgeworth’s Contract Curve is a locus of points of tangencies of the successive

isoquants of two products, representing efficient allocation of resources in production.

161
Any point on the contract curve is efficient in the sense that movement away from the curve
to the right or to the left results in a fall in output of at least one of the two goods. At point
N, for example, the firm produces X2 amount of X and Y3 amount of Y. To produce X2amount
of X, the firm usesLxamount of labor and Kx amount of capital. The remaining amount of
labor (Ly) and capital (Ky) will be used for the production of Y. Movement along isoquant X2
or isoquant Y3 toward the contract curve increases the output of Y or X respectively with the
output of the other remaining the same. Movement from point N to point a enables the firm
produce the same amount of X but more of Y. Therefore, point a represents more efficient
allocation than N. Similarly, movement from point N to point b enables the firm produce the
same amount of Y but more of X. Like point a, point b also represents efficient allocation of
resources. Anywhere between a andb along the contract curve, the firm can produce more of
one good without reducing the other.

The PPC is derived from the efficient combinations of X and Y defined by the contract
curve. Any point on the PPC corresponds to a point on the contract curve. At point a on
Edgeworth’s contract curve in Figure 4.21 below, the output combination is (X2, Y4); while
the output combination at point b on the same curve is (X3, Y3). Movement from a tob
involves rise in X and fall in Y, because resources (L and K) need to be moved away from
production of Y to production of X. With constant amount of factors, since increasing one
product requires fall in the other, the PPC will be downward sloping.

dY

The slope of the PPC is dX and it measures the rate at which one product is transformed

into the other in production and is accordingly referred to as marginal rate of product
transformation of X for Y (MRPTX,Y).

162
 Y

Y4 a

Y3 b
PPC

0 X2 X3 X

Figure 4.21: Production Possibility Curve.

Edgeworth’s contract curve (and the PPC) is derived from points of tangencies of successive
isoquants. At the tangencies the slope of the successive isoquants of X and Y must be the
same. Therefore,

MRTS LX, K MRTS LY, K

MRTSLX, K MRTSLY, K
where, is the slope of the X isoquants and is the slope of the Y
isoquants.

dK X MPL , X
X 
MRTS L,K dL X = MPK , X and
But =

dK Y MPL ,Y
MRTS LY, K  
dLY MPK ,Y

where, MPL, X = the MP of labor in the production of X.

MPK, X = the MP of capital in the production of X.

MPL, Y = the MP of labor in the production of Y.

MPK, Y = the MP of capital in the production of Y.

dK X dK Y MPL , X MP L ,Y
 
MPK , X MPK ,Y
Therefore, along the PPC dL X = dLY = =

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Increase in the quantity of good X or good Y results from increase in L, K, or both.
Therefore:

X X
dX  dLx  dK x
Lx K x MPL , X dL X  MPK , X dK X
=

Y Y
dY  dL y  dK y
L y K y MPL ,Y dLY  MPK ,Y dK Y
=

Any point along the PPC represents full employment of factors. Thus, to increase the
production of one good, say Y, resources must be transferred from the production of X,
resulting in decline in X. Therefore:

dLY=-dLX and

dKY = -dKX

i.e. rise in labor in the production of Y is equal to the fall in labor in the production of X.
Similarly, the rise in capital in the production of Y is equal to fall in labor in the production
of X.

dY MPL ,Y dLY  MPK ,Y dK Y

 
dX MPL , X dL X  MPK , X dK X
Slope of the PPC is

Dividing both the numerator and the denominator by dLY

 dK 
 MPL ,Y  MPK ,Y  Y 
dY dLY
   
dX  MP dL X  MP dK X 
 L, X
dLY
K ,X
dLY 

But, dLY=-dLX

 dK Y 
 MPL ,Y  MPK ,Y 
dY dLY
   
dX   ( MP  MP dK X )
 L, X K ,X
dL X 

164
  MPL ,Y dK Y 
 MPK ,Y (  ) 
dY  MPK .Y dLY 
 
dX  MPL , X dK X 
  MPK , X (  )
 MPK , X dL X 

dK X dK Y MPL , X MP L ,Y
 
Since dL X = dLY and MPK , X = MPK ,Y the terms in brackets are equal and cancel out

each other.

MP
K ,Y
dY

Therefore the slope of the PPC = dX = MPK , X

MP
dY L ,Y
 MPL , X
It can also be shown that dX = using the same procedure.

MP
K ,Y MP
dY L ,Y

dX = MPK , X = MPL , X

4.2.9.2. The Isorevenue Curve

Colleague,can you define isorevenue curve? Compare your definition with the following.

Definition: An isorevenue curve shows the different combinations of two goods (X and Y)
that yield the same level of revenue to the firm.

Total revenue is defined as the product of output price and quantity sold. With two products

involved revenue is:

R PX X  PY Y

Solving for Y yields the equation of the isorevenue curve.

PY Y R  PX X

R PX
Y  X
PY PY

R / PY
Isorevenue curve

165
 PX

Slope=
PY

0
R / PX X
Figure 4.22: The Isorevenue Curve.

Isorevenue curves have the feature that the farther away from the origin an isorevenue curve
lies, the higher the level of revenue it represents and the closer it lies to the origin the lower
the level of revenue it represents.

4.2.9.3. Equilibrium of the Firm

Can you determine firm’s equilibrium based on the concepts discussed up to now? Ok. Let
us determine together.

Given the PPC of the firm and a set of isorevenue curve, the equilibrium of the firm is
defined at the tangency of the PPC with the highest possible isorevenue curve.

Y
A

Y* e

B
0 X* X
Figure 4.23: Equilibrium of the firm.

The isorevenue curve shows the highest attainable level of revenue for any given efficient
allocation of resources (efficient combinations of X and Y).

We have seen that all points on the PPC are efficient. The problem to the firm, then, is
identifying the best among those technically efficient combinations of X and Y. The best
combination for a firm that aims at maximizing its profit is defined at the tangency of the
PPC with the highest possible isorevenue curve. Any point on the PPC that lies to the left or
to the right of point e is associated with a lower isorevenue curve representing low level of

166
revenue. Isorevenue curves to the right of AB are desirable but are not attainable given the
fixed amount of L and K. Therefore, the highest attainable level of revenue is the one given
by AB and the equilibrium combination of X and Y is (X*, Y*).

At the tangency (point e), the slope of the PPC is equal to the slope of the isorevenue curve.

MPK ,Y MPL ,Y PX
MRPTX ,Y   
MPK , X MPL , X PY

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UNIT FIVE

5. THEORY OF COSTS
5.1Basic Concepts of Costs

Objectives

At the end of this section, you will be able to:

 Explain the differences between implicit and explicit costs, economic and accounting
costs, and short-run and long-run periods; and

 Illustrate why economists consider opportunity costs in calculating costs of

production.

5.1.1. Explicit and Implicit costs

The basic factor underlying the ability and willingness of firms to supply a product is the
cost of making that product. The words cost and price are often confusing, especially for
non-economists. When we discuss costs we mean how much does something cost to
produce? This might be expressed as an opportunity cost, or in a currency such as dollars,
birr, etc…. When a price is mentioned, we mean the amount that the consumer pays. So,
cost is a payment made by producers whereas price is a payment made by consumers.

Before moving to the details of cost theory, it is important to make a distinction between
explicit and implicit costs.

Explicit Cost: The term explicit cost refers to the payments made to those outsiders who
will supply labor services, raw materials, fuel, transportation services, power, etc., to the
firm. It is also called money costs.

Implicit Cost: The term, implicit cost, refers to the cost/value of self-owned or self-
employed resources and it is also called imputed costs.

The total cost of production is the sum of explicit and implicit costs.

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5.1.2. Economic and Accounting Costs

Ok! Let us discuss it together. An accountant, while calculating the cost of production may
just take into account the explicit cost items only. Economists, on the other hand, base their
estimate of production costs on the concept of opportunity cost which is measured in terms
of forgone alternatives.As we have defined in unit one,Opportunity cost is the most
attractive alternative forgone or the next best choice sacrificed in the event of producing
goods or rendering services.

To illustrate the distinction between accounting costs and economic costs, consider the case
of a market trader who sells umbrellas. For simplicity, assume that the trader sells the
umbrellas he/she purchases during the relevant period. The accountant might prepare the
simplified accounts in the following way. If the total sale of the umbrellas is birr 30,000, the
costs include purchase price of, say birr 20,000, and overhead expenses incurred by the
trader of, say birr 4,000 for hiring market place and cost of transport. From the accountant’s
viewpoint, therefore, the trader has made a net profit of birr 6,000.

The economist, adopting the opportunity cost principle, would argue that account must also
take the opportunity cost to the market trader of using capital and labor in this particular
way. Suppose that the trader has funds worth birr 5,000 tied up in the business, the trader
could have lend this amount at the market rate of interest, say 10 per cent per annum, and
would have received birr 500 per annum. This sum is the opportunity cost of tying up funds
in the business of selling umbrellas. The trader might also have taken up employment
elsewhere and earned, say birr 8,000 per annum. These additional opportunity costs, totaling
birr 8,500 per annum, which are not included in the accountant’s calculations, are added to
the cost of sales and expenses in the economist’s calculation of opportunity costs. Thus, the
total opportunity cost of being a market trader is birr 32,500 per annum. With the revenue
from sales of only birr 30,000, from economists point of view, the trader has made a loss of
birr 2,500 over the relevant period.

169
look at the following figure for simplified presentation of economic and accounting costs.

Economic
Profit Accounting
Opportunity Profit
cost of capital
+ any other
implicit costs Total Revenues
Economic Costs
Explicit Accounting
(Accounting) Costs
Costs

Figure 5.1: Simplified view of Economic and Accounting Costs

5.1.3. Short-run and the Long-run Periods

Look at the concepts of the short-run and the long-run periods both from the point of view of
production theory and cost theory.

Short-runis that period of time over which the amount of at least one input cannot be
changed. That means we have two major categories of inputs in this period: fixed inputs and
variable inputs. Usually capital equipment and entrepreneurship are considered as fixed
inputs and labor and raw materials can be taken as variable inputsin the short-run.
Consequently costs are of two types: fixed costs and variable costs. During this period, the
firm can expand or decrease its output only by varying the amounts of variable inputs.

Long-run, on the other hand,is that period of time over which all factors of production can
be varied. That means, in the long-run, all inputs are variable and hence all costs are also
variable.

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2:- Short-run Theory of Costs

Objectives

At the end of this section, you will be able to:

 Define fixed and variable costs;

 Illustrate the shapes of the curves for the seven cost functions;

 Depict the relationships among marginal cost, average variable cost, average fixed
cost and average total cost;

 Show how marginal cost can be derivable both from total cost and from average total
cost; and

 Illustrate how average fixed cost changes as the level of output increases.

5.2.1. Fixed Costs and Variable Costs

Costs are broken down into several parts and looked at in different ways. Before we start,
we have to make one basic assumption that the firm is operating in the short-run time period.
As it has been briefly indicated, we have two major categories of costs in the short-run:
fixed costs and variable costs.

5.2.1.1. Total Fixed Cost (TFC)

Fixed costs are the costs of the investment goods used by the firm on the idea that these
reflect a long-term commitment that can be recovered only by wearing them out in the
production of goods and services for sale. If cement is to be produced, then a factory is
required. The land, the factory building, the machinery and office equipment must be bought
or rented. These costs are called fixed costs and must be paid even when the factory has not
produced anything. Fixed costs in total do not vary with the changes in the level of output of
a firm. Fixed costs are associated with the existence of a firm’s plant itself, and they have
got to be paid even if the firm’s rate of output is zero.

Salaries paid to the top management and key personnel, rent paid to the factory building,
interest paid on loans raised, and insurance premiums, etc., are examples of fixed costs.

C (Cost)

171

TFC Curve TFC Curve

TFC Curve
 Figure 5.2: Total Fixed Cost Curve

As it is indicated in Figure 5.2, the fixed cost curve starts at some point above the origin (at
Ĉ) and it is horizontal. It indicates that the firm incurs fixed costs even when its level of
output is zero.

5.2.1.2. Total Variable Cost (TVC)

Variable costs are costs that can be varied flexibly as conditions change. Variable cost
increases with the increase in the level of output of a firm. The variable costs of production
are incurred by a firm only when there is an output.

Wages paid to laborers, payments made to the raw material suppliers, payments made to the
fuel suppliers and transportation agencies, etc., can be cited as examples of variable costs of
production.

As indicated in Figure 5.3 below, the TVC curve starts from the origin and it slopes
positively upwards. It indicates that the variable cost is zero when the level of output of a
firm is zero and these costs increase with the increase in the level of output (Q).

C TVC Curve

Q
O

Figure 5.3: Total Variable Cost Curve

172
5.2.1.3. Total Cost (TC)

Colleague, can you compute total cost, given fixed and variable costs? Good. Total cost is
simply the sum of total fixed cost and total variable cost (i.e., TC = TFC + TVC). In Figure
5.4 below, the TC and TVC curves are ‘parallel’ and it reflects that the total cost of
production in a firm increases in proportion to the increase in total variable cost with an
increase in the level of output. The distance between the two curves (TC and TVC) is the
amount of total fixed cost.

C TC

TVC

TFC

Figure 5.4: TC, TVC, and TFC Curves

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5.2.2. Unit Costs and a Marginal Cost

5.2.2.1. Unit Costs (Average Costs)

Colleague, costs may be more meaningful if they are expressed on a per-unit basis as
averages per unit of output (Q). In cost theory, we have three averages: average total cost
(ATC), average variable cost (AVC), and average fixed cost (AFC). ATC is the sum of
AVC and AFC. These three averages can be computed from their respective totals as
follows:

TC TVC TFC
ATC  AVC  AFC 
Q Q Q ATC  AVC  AFC
C

ATC

AVC

AFC
Q

Figure 5.5: The Three Average Cost Curves

As you can see in the above figure, ATC and AVC curves are ‘U-shaped’, while AFC is of
rectangular hyperbola in shape.

5.2.2.2. Marginal Cost (MC)

Dear colleague,let us turn to the discussion of another important cost function: marginal
cost. Can you define marginal cost?

Marginal cost of production is nothing but an extra cost incurred by a firm while producing
an extra unit of output, or it is the change in total cost as a result of the change in output by
one unit. That means, it is the cost of producing one extra unit.

the change in total cost TC

Marginal cost  MC 
the change in output Q

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For a very small change, marginal cost is computed as a derivative of the total cost function
dTC
MC 
with respect to change in output as dQ

Now, let us introduce and overlay marginal cost curve over the three average cost curves.

MC
ATC

AVC

AFC

Q
Figure 5.6: Marginal Cost Curve and the Three Average Cost Curves

The shape of a marginal cost curve is also ‘U-shaped’ as it is indicated in the above figure.

The following table indicates how the short-run cost curves vary with the level of output,
and how these costs can be computed.

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Table 5.1: Variation of Short-run Cost with Output

Output (Q) T F C T V C T C A F C A V C A T C M C
0 4 8 0 4 8 - - - -
1 4 8 2 5 7 3 4 8 2 5 7 3 2 5
2 4 8 4 6 9 4 2 4 2 3 4 7 2 1
3 4 8 6 6 1 1 4 1 6 2 2 3 8 2 0
4 4 8 8 2 1 3 0 1 2 2 0 . 5 3 2 . 5 1 6
5 4 8 1 0 0 1 4 8 9 . 6 2 0 2 9 . 6 1 8
6 4 8 1 2 0 1 6 8 8 2 0 2 8 2 0
7 4 8 1 4 1 1 8 9 6 . 9 2 0 . 1 2 7 2 1
8 4 8 1 6 8 2 1 6 6 2 1 2 7 2 7
9 4 8 1 9 8 2 4 6 5 . 3 2 2 2 7 . 3 3 0
1 0 4 8 2 3 0 2 7 8 4 . 8 2 3 2 7 . 8 3 2
1 1 4 8 2 7 2 3 2 0 4 . 4 2 4 . 7 2 9 . 1 4 2
1 2 4 8 3 2 1 3 6 9 4 2 6 . 8 3 0 . 8 4 9
5.2.3. Geometry of Average and Marginal Costs

Dear learner, do you remember how we geometrically derived average and marginal product
curves from total product curve in unit four? Can you derive, geometrically, average and
marginal cost curves from total cost curve in a similar fashion? Good. We will do it
together.

As the average and marginal product curves are derived geometrically from the total product
curve (discussed in unit 4), the average and marginal cost curves may be derived from the
corresponding total cost curves.

TFC
AFC 
Since Q , AFC is given by the slope of a ray from the origin to a point on the TFC
curve.

176
 C
C

TFC

AFC
Q Q
O a b c O a b c
(b)
(a)

Figure 5.7: Derivation of AFC Curve from TFC Curve

Consider the three rays on panel (a) of the above figure. The slope of these rays gets on
declining as we move from quantity levels of a toc. Hence, AFC at a> AFC at b> AFC at c
as it is indicated on panel (b) of the same figure.

We can follow similar procedure to derive AVC curve from TVC curve and ATC curve
from TC curve.
C TVC

AVC

Q
d e f g d e f g
(a)
(b)
Figure 5.8: Derivation of AVC Curve from TVC Curve

TC
C C
ATC

Q C

h 177 h
(a) (b)
 Figure 5.9: Derivation of ATC Curve from TC Curve

As we move from left to right on total cost curve indicated on panel (a) of the above figure,
the slope of a ray from the origin to a point on TC curve first decreases,then attains its
minimum at h, and finally increases. As a result, the shape of ATC curve becomes as it is
indicated on panel (b) of the above figure.

MC, on the other hand, can be given by the slope of TVC or the slope of TC curves (since
TVC and TC curves are ‘parallel’) at a given output level. As we move from left to right on
these two curves, the slope initially decreases, reaches a minimum, and then increases and
hence is the shape of MC curve.

5.2.4. Nature and Relations among ATC, AVC, AFC and MC

Colleague, can you explain the relationships among the different cost curves we discussed?
Based on the discussions made earlier, we can state the following nature of the cost curves
and relationships among these curves:

1. AFC approaches both axes asymptotically.

2. Both AVC, ATC, and MC curves first decline, reach a minimum point, and then rise.
The U-shapes of AVC and ATC reflect the law of variable proportions discussed in
unit four. However, the minimum point of the ATC curve occurs to the right of the
minimum point of AVC. This is due to the fact that ATC includes AFC, and the
latter falls continuously with increases in output. After the AVC has reached its
lowest point and starts rising, its rise over a certain range is offset by the fall in the
AFC so that the ATC continues to fall over that range despite the increase in the
AVC. However, the rise in AVC eventually becomes greater than the fall in the AFC
so that the ATC curve starts increasing.

3. As AFC approaches asymptotically close to the horizontal axis, AVC approaches

ATC asymptotically.

178
 4. MC equals both AVC and ATC when these curves attain their minimum values; it
lies below both AVC and ATC curves over the range in which these curves decline;
and it lies above these curves when the curves are rising.

5.2.5. Product and Cost Curves: A Comparison

Colleague, let us compare product and cost curves. Follow attentively.

In order to simplify our analysis, let us assume that we have one variable input labor (L)
with labor price of wage (w). Hence, total variable cost is the product of L and w (i.e.,
TVC=wL).

TVC wL  L  1  Q
AVC    w   w  APL 
Q Q Q
   APL  L
, because average product of labor

w
 AVC 
APL

This implies that we have inverse relationships between AP and AVC. As AP first increases,
reaches a maximum and then declines, AVC first declines, reaches a minimum and then
rises.

Can you relate marginal cost with marginal product in a similar way? Ok.

Similarly,

TVC wL  L
MC   w
Q Q Q . This is because wage (w) is assumed to be constant.

 1  w Q
 MC  w   MPL 
 MPL  MPL , because marginal product of labor L

This also implies that MC and MP are inversely related. As MP first increases, reaches a
maximum and then declines, MC first decreases, reaches a minimum and then increases.
Look at Figure 5.10 below.

179
 and
MP
AP AP
MP
Labor

MC
AVC
Cost

Output

Figure 5.10: Relationship between Product and Cost Curves

Generally, falling marginal cost reflects rising marginal product and rising MC reflects
falling MP. Falling AVC indicates rising AP, and rising AVC indicates falling AP. AP equal
to MP at the point where MC is equal to AVC. At these equality points, average product is
at its maximum and AVC is at its minimum.

The marginal product curve lies above the average product curve in the region, where the
MC lies below AVC. The marginal product curve lies below average product curve in the
region, where the AVC curve lies below the MC curve.

3. Long-run Theory of Costs

Objectives

At the end of this section, you will be able to:

 Define the long-run average cost curve and illustrate its shape;

 Show how a long-run marginal cost curve can be derived from the short-run
marginal cost curves;

 Explain the distinction between economies and diseconomies of scale;

 Explain the role of economies and diseconomies of scale in determining the shape of
long-run average cost curve; and

 List factors contributing to internal economies and external economies, and internal
diseconomies and external diseconomies.

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5.3.1. Long-run Average Cost (LRAC)

Dear learner, thus far, we have not considered the long-run in cost theory. We have defined
the long-run as a period long enough so that all inputs are variable. In other words, a
business can vary all of its inputs and change the whole scale of production in the long-run.
In particular, this includes capital, plant, equipment, and other investments that represent
long-term commitments.

We will now think a bit about the long run, using the concept of average cost.

Suppose you were planning to build a new plant, perhaps to set up a whole new company
and you know about how much output you will be producing. Then you want to build your
plant so as to produce that amount at the lowest possible average cost.

To make it a little bit simpler, we will suppose that you have to pick just one of the three
plant sizes: small, medium, and large. Average cost curves for the small (ACs), medium
(ACm), and large (ACL) plant sizes are as indicated in Figure 5.11 below:

ACs
C ACm

Cm ACL

Cs
LRAC

Q
Q1 Q2 Q3

Figure 5.11: Short-run Average Cost Curves for Different Plant Sizes and the LRAC

If you produce Q1 units, the small plant size gives the lowest cost as compared to medium
sized one (i.e., Cs<Cm). If you produce Q2 units, the medium plant size gives the lowest cost
and if you produce Q3 units, the large plant size gives you the lowest cost. Now, we can join
these lowest points of average cost curves for different plant sizes with a line, called long-
run average cost curve (LRAC).

181
The long run average cost, the lowest average cost for each output range, is described by the
lower envelope curve, shown by the thick curve (in Figure 5.11 above) that follows the
lowest of the three short run curves in each range.

More realistically, an investment planner will have to choose between many different plant
sizes or firm scales of operation, and so the long-run average cost curve will be smooth, as
illustrated below:

LRAC
C

Figure 5.12: Long-run Average Cost Curve Q

As shown in the above figure, each point on the LRAC curve corresponds to a point on the
short-run average cost (SRAC) for the plant size or scale of operation that gives the lowest
average cost for that scale of operation. The LRAC curve envelopes a number of short-run
average cost curves, and hence it is also called an envelope curve.

Generally, the LRAC is more or less ‘u-shaped’, and the idea is that:
 for small outputs, indivisibilities predominate, and so long-run average cost declines
with increasing output;

 for intermediate outputs, operations can be expanded roughly proportionately, while

tendencies to increasing and decreasing costs, if any, offset one another; and

 for large outputs, the problems of management predominate, and hence long-run
average cost increases with increasing output.

5.3.2. Long-run Marginal Cost (LRMC)

Colleague, can you draw the long-run marginal cost curve based on short-run marginal cost
curves? Ok. In fact, it is not simple as in the case for LRAC. Let us see it.

The long-run marginal cost is derived from the short-run marginal cost curves, but it does
not ‘envelope’ them. It is formed from points of intersection of the short-run marginal cost

182
(SMC) curves with vertical lines (to the x-axis) drawn from the point of tangency of the
corresponding short-run average cost (SAC) curves and LRAC curve.The LRMC curve
crosses the LRAC curve when the latter attains its minimum value. Look at the following
figure.

Cost
LRMC
SAC1 SMC1
LRAC

Output

Figure 5.13: Derivation of Long-run Marginal Cost Curve

5.3.3. Economies of Scale

Colleague, can you say something about economies of scale before looking into this concept
together? Can you remember the concept of returns to scale discussed in unit four? What are
increasing returns to scale, constant returns to scale, and decreasing returns to scale? Please
try to discuss.

In our pictures of long run average cost, we see that the cost per unit changes as the scale of
operation or output size changes. Terminologies for describing these changes are increasing
returns to scale, constant returns to scale, and decreasing returns to scale.

Increasing returns to scale: This is the case ofdecreasing cost. Average cost decreases as
output increases in the long-run, and it is in the declining part of the LRAC
curve.Economists usually explain increasing returns to scale by indivisibility, i.e., some
methods of production can only work on a large scale, either because they require large-
scale machinery, or because they require a great deal of division of labor. Since these large-
scale methods cannot be divided up to produce small amounts of output, it is necessary to
use less productive methods (indivisible plant) to produce the smaller amounts. Thus, costs
increase less than in proportion to output and average costs decline as output

183
increases.Increasing Returns to Scale is also known as economies of scaleordecreasing
costs.

Constant returns to scale: This is the case of constant costs. Average cost remains constant
as output varies in the long-run. We would expect to observe constant returns where the
typical firm (or industry) consists of a large number of units doing pretty much the same
thing, so that output can be expanded or contracted by increasing or decreasing the number
of units. Consider the case where we need one machinist to do a series of operations to
produce one item of a specific kind. If you want to double the output you had to double the
number of machinists and machine tools.Constant Returns to Scale is also known as
constant costs.

Decreasing returns to scale:This is the case of increasing costs.Average cost increases as

output increases in the long-run, and it is in the rising part of the LRAC curve.Decreasing
returns to scale are associated with problems of management of large, multi-unit firms.
Again think of a firm in which production takes place by a large number of units doing
pretty much the same thing, but the different units need to be coordinated by a central
management. The management faces a trade-off. If they don't spend much on management,
the coordination will be poor, leading to waste of resources, and higher cost. If they do
spend a lot on management, that will raise costs in itself. The idea is that the bigger the
output is, the more units there are, and the worse this trade-off becomes.So, the costs rise
either way.Decreasing Returns to Scale is also known as diseconomies of scaleor
increasing costs.

Did you understand the concept of economies of scale? Good. Now, let us illustrate the same
concept, but pictorially (Figure 5.14 below).

Diseconomies of scale LRAC

Economies of scale

Constant costs

Figure 5.14: Long-run Average Cost and Economies of Scale

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Causes for Economies and Diseconomies of Scale

A. Causes for Economies of Scale

Dear learner, we have said that economies of scale occur when long-run average costs are
falling as output is increasing. Please try to list the different causes for economies of scale.
What are the causes for internal economies and for external economies? Try to list them and
compare it with our list indicated below.

Indeed, there are different causes of economies of scale and they are usually listed under two
broad headings:internal economies and external economies.

i) Internal Economies of Scale

Internal economies of scale occur as the output of the individual firm increases and the
causes for internal economies can be the following:

1. Fixed Costs are shared

Assume that the fixed cost of producing a car at a factory is birr120 million. If only one car
was made, all of the fixed costs are born by this car alone. If two cars are produced the
average fixed cost falls rapidly. Therefore, the greater the level of output the lower are the
average fixed costs. The average fixed cost curve continues to fall, but note that it will never
reach the horizontal axis, as AFC will always be a positive number (Table 5.2 below).

Table 5.2: Variation of AFC with the level of output

Quantity Fixed Cost Average Fixed Cost

(number of car) (in million Birr) (in million Birr)

1 1 2 0 1 2 0
2 1 2 0 6 0
3 1 2 0 4 0
4 1 2 0 3 0
5 1 2 0 2 4
6 1 2 0 2 0

Thus, decline in the fixed costs as output expands is one cause for economies of scale.

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2. Financial Economies

Assume two firms, one large and the other small. Where do you expect a lower interst rate
for borrowing? Where do you expect a better purchase discount?

A large firm might be able to borrow at lower rates of interest than a smaller one. Again,
when raw materials, components, office supplies, etc. are bought, it is usual to receive a
discount for large quantities bought. The larger the quantity purchased the bigger the
percentage discount. The office work needed for a big order is the same as that for a small
order. These are sometimes called bulk-buying or purchasing economies.

3. Managerial Economies

The greater the output of a firm is, the greater the revenue will be. This allows the firm to
hire more workers, and therefore gain advantages from the division of labour. Small firms
cannot afford to permanently hire lawyers, accountants, human resource managers, etc.,
whereas larger firms can. Note for your understanding that a large ship and a small ship both
need a captain with maritime skills. This means large firms will have better managerial
economies.

4. Container Principle

Look at the following cubes with sides of 1cm and sides of 3cm. A cube with sides of 1cm
length has an area of 6cm squared (1cm x 1cm x 6), and a volume of 1 cm cubed (1cm x
1cm x 1cm). A cube with sides of 3cm has an area of 54cm squared (3cm x3cm x6) and a
volume of 27cm cubed (3cm x 3cm x 3cm).

1
3
1
1
3

3
(a) (b)

Figure 5.15: Demonstration of Container Principle

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Expressed as a ratio of area to volume for the cube with sides of 3cm, this is54: 27 which is
the same as 2 to 1. This means, if we want to construct a container using metal sheet, we
need 2cm squared metal sheet for every 1 cm cubed volume. For a cube with sides of 1cm,
however, area to volume ratio is 6:1. This, again, means we need 6cm squared metal sheet
for every 1 cm cubed volume.

We can now compare the required area for the same volume of 1 cm cubed. We require
smaller area of 2 cm squared for the larger cube with sides of 3 cm long as compared to area
of 6 cm squared for the smaller cube with sides of 1 cm long.

What this demonstrates is that the 3cm sided cube can hold a greater proportionate volume
than a 1cm sided cube. This principle helps explain why large oil tankers, factory buildings,
chemical plants, etc., are more economical to build than small ones.

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5. Indivisibilities

Some machinery or processes only make sense for large firms. For example, assume we
have two farm owners; one with large farm size and the other with very small land size.
Where do you expect is purchasing a tractor economical? Good. A small farm of only a few
acres cannot make use of a big combine harvester.

ii) External Economies of Scale

Based on the definition we provide for internal economies, can you explain external
economies of scale and provide its possible causes? Anyhow, external economies of scale
occur as the output of the industry increases, and the possible causes for external economies
can be the following:

1. Labour

As an industry builds in size, a pool of trained labor emerges that each individual firm can
make use of. This means, because of emergence of trained man power in the industry, firms
in that industry will benefit economies of scale.

2. Cooperation

Colleague, can you guess how cooperation brings external economies of scale? Good. Firms
in industries often cooperate so as to get more advantage over individual firms.For example,
farmers’ cooperatives arise to buy or sell products more cheaply than the farmers could do
alone, and as a result, they will benefit more as compared to individual farmers.

B. Causes for Diseconomies of Scale

Can you indicate causes for diseconomies of scale? Anyway, diseconomies of scale occur
when long-run average costs are rising as output is rising. It can also be of internal
diseconomies or external diseconomies. The possible causes for these diseconomies are
indicated below.

i) Internal Diseconomies of Scale

Internal diseconomies occur when long-run average costs are rising as the output of the firm
is rising. It can be caused by the following:

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1. Interdependency

Colleague,can you explain the disadvantages of having many departments in a given firm?
Good that is internal diseconomies. In large firms with many different departments, eachpart
of the company becomes interdependent, and hence, a machine failure in the packaging
department may result in stopping the whole production line, for example.

2. Coordination and Communication

Large firms have long chains of command. What do you think is the negative effect of
having long chains of command? The possible consequence can be information from the top
management may not be communicated to the production line properly and vice-versa.

3. Industrial Relations

Colleague, can you depict the effect of unhealthy relationship between the management and
the work force in the production process? Anyhow, because of the lack of contact between
senior management and the work force, the workers may feel insignificant or uncared for,
and as a result industrial disputes may arise and production may suffer.

ii) External Diseconomies of Scale

As output increases in an industry, each of the factors of production becomes scarcer, and as
they become scarcer, their prices increase. This will adversely affect the operation of
individual firms in that industry.

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UNIT SIX

MARKET STRUCTURES

1. Market Structures and Perfectly Competitive Market

Introduction

In this section, the meaning of market structure and the different types of market structures will
be briefly discussed followed by the characteristics of perfectly competitive market.

Objectives

At the end of this section, you will be able to:

 Define market structures and perfectly competitive market;

 Distinguish the different market structures;

 Describe the major characteristics of perfectly competitive market structure; and

 Provide real world examples for the different market structures.

6.1.1. Market Structures

Colleague,can you define market structure? What are the different types of market structures?
Anyhow, let us start our discussion with the definition of market structure.

Market structure refers to the nature and degree of competition within a particular market. It
shows the number and relative size of firms in an industry. Market structures can be
characterized by sellers or buyers or both; and in fact, most economics texts classify markets by
sellers.

Based on sellers, economic analysis classifies markets into different categories, or structures
depending on the degree of competition prevailing in them. The spectrum (continuum) of market
structure ranges from perfect competition to monopoly as briefly defined hereunder.

1. Perfect Competition: This is a theoretical market structure in which there are many buyers and
sellers with no individual power to influence market price.

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2. Monopolistic Competition: In this market there are many firms producing differentiated
products. This market structure is sometimes called competition among the many.

3. Oligopoly: Here, a few interdependent firms dominate the market for the product
(differentiated or similar products). This market is sometimes called ‘competition among the
few’ and is relatively common in manufacturing industries. Duopoly is a special case of
oligopoly where two firms dominate the entire market for the product.

4. Monopoly: This refers to a single supplier for the whole market.

The nature and degree of competition varyin these markets. Examples of these market structures
are presented in the following table.
Table 6.1: The different market structures

Type of market Number of firms E x a m p l e s

Perfect competition V e r y m a n y Agricultural markets (approximately)
Monopolisticcompetition M a n y / s e v e r a l Builders, restaurants, suiting, …
O l i g o p o l y F e w Cement, cars, electrical appliances
M o n o p o l y O n e Local water company, electricity, trainoperators (over particular routes)

6.1.2. Perfect Competition

Can you list some of the characteristics of perfectly competitive market? Now, let us continue
our discussion with the basic characteristics of perfectly competitive market.

In a perfectly competitive market, no individual buyer or seller has any influence over the market
so that market forces have full rein to determine price and output. Perfect competition is a
theoretical market structure where a firm will have no customers at all if it sets price above the
competitive price. Agricultural markets can approximate perfect competition where an individual
producer has no effect on market price.

A market is said to be operating under perfect competition when the following requirements
(assumptions) are met:

1. There must be a large number of buyers and sellers. Both buyers and sellers do not have an
influence on market price. Each firm is small in relation to the size of the whole market. Such
firms are described as price takers, for they take the market price as given and adjust their

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actions to it. As a result, firms can effectively be regarded as facing a perfectly elastic demand
curve for it can sell whatever it produces at a ruling market price.

2. Products must be homogeneous. The product of any one firm is identical to the products of
all other firms, i.e., products are perfect substitutes for one another. Buyers must be able to
choose from a large number of sellers of a product that the buyers believe to be the same.

3. There must be freedom of entry and exit. There are no barriers to new firms entering the
industry and no barriers to existing firms leaving the industry.

4. Both buyers and sellers have perfect knowledge. It is assumed that all participants in the
market are perfectly well informed about prices, quality, output levels, and all other market
conditions.

5. Factors of production are perfectly mobile. It is assumed that land, labor, and capital can
switch immediately from one line of production to another, for these factors of production are
free to move from one firm to the other throughout the economy.

These are the major assumptions in perfectly competitive market structure. However, in the real
situation, it is extremely difficult to satisfy all the conditions stipulated; and as a result, imperfect
markets in all nations are ruling the economic scene.\

2:Short-run Equilibrium Conditions in Perfect Competition

Introduction

Colleague, in this section, short-run equilibrium conditions for an individual perfectly

competitive firm and for the whole industry will be discussed. First, the nature of demand curve
will be presented followed by the revenue, marginal revenue, and average revenue functions.
Then, profit function and conditions for profit maximization will be discussed.

Objectives

At the end of this section, you will be able to:

 Draw demand and revenue lines of a perfectly competitive firm;

 Explain the conditions for equilibrium of a firm in perfect competition;

 Identify break-even and shut-down points of a firm in perfect competition;

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  Explain how supply curve of a firm can be determined;

 Explain why the firm should continue to produce as far as price is greater than AVC at
equilibrium, even if it is incurring a loss; and

 Depict short-run equilibrium conditions for perfectly competitive industry.

6.2.1. Short-run Equilibrium of a Firm

Can you graphically illustrate demand, revenue, average revenue, and marginal revenue lines for
perfectly competitive market? Anyhow, the nature of these lines may be different from your
expectation. Let us discuss.

Before looking into the conditions for equilibrium, it is very important to introduce demand,
revenue, average revenue, marginal revenue, and cost concepts in perfectly competitive market
structure.

Demand Curve: Since a perfectly competitive firm is a price taker, horizontal demand curve is
its distinguishing feature. If a perfectly competitive firm sets its own price above the competitive
price (Pc), a firm will find that it will eventually have no customers at all.

PC Demand

Figure 6.1: Demand Curve of a Firm under Perfect Competition

Revenue Curve: Revenue is the income to the firm from the sales of its output. It is price
multiplied by the number of units sold (i.e., R=PQ). Since price is constant in perfectly
competitive firm, revenue curve will be a straight line through the origin. Look at panel (a) of
Figure 6.2 below.

The slope of revenue line is marginal revenue which is the change in total revenue as a result of
changing the level of sales by one unit. It will be equal to the constant price level at all units of
output.

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As average revenue is total revenue divided by level of output, it is also the same as the constant
price level. Hence, in perfectly competitive market, demand curve of a firm is equal to marginal
revenue (MR) and also to average revenue (AR) as it is indicated in panel (b) of the following
figure.

. Revenue line P
R

P=MR=AR

Q
O Q
O
(a) (b)
Figure 6.2: Revenue, Marginal Revenue, and Average Revenue Lines for Perfectly
Competitive Firm

let us introduce the total cost curve discussed in unit five of this module as indicated in Figure
6.3 below.

TC
R, C TR

max

O Q
Q1 Qe Q2

Figure 6.3:TR and TCCurves of a Firm in Perfectly Competitive Market

The firm is in equilibrium when it maximizes its profit (), defined as the difference between
total revenue (TR) and total cost (TC).

 = TR - TC

The equilibrium may be shown graphically in two ways: Either by using TR and TC curves or
MR and MC curves. As indicated in the above figure, profit is maximum at a point where the
distance between TR and TC is the largest (at Qe). Profit is negative within the output ranges of

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zero to Q1 and beyond Q2. This is because the cost curve is above revenue line within these
ranges. Profit is positive in the output range of Q1 to Q2 as revenue is above cost curve in this
range. The profit function, therefore, will have the shape indicated in Figure 6.4 below where it
attains its maximum at the same output level of Qe.

0 Q

Q1 Qe Q2 π

Figure 6.4: Profit Curve

The total-revenue-total-cost approach is awkward to use when firms are combined together in the
study of the industry. The alternative approach, which is based on MC and MR, is assumed to be
superior as it uses price as an explicit variable. This is demonstrated hereunder.

At the point where the distance between TR and TC curves is widest, the slopes of these curves
are equal, and these slopes are MR and MC curves, respectively. This means, the firm is in
equilibrium (maximizes its profit) at the level of output defined by the intersection of the MR and
MC curves. Indeed, this approach is superior to the TR-TC approach.

Figure 6.5:MR-MC Approach to Determine Equilibrium

Colleague, in the above figure, equilibrium is at point e where MR is equal to MC. Can you
identify profit region in the figure? Let us define profit based on the above figure.

- Since TR is equal to price multiplied by quantity, total revenue in the above figure is the area of
rectangle aOQee. (Because price is segment Oa and quantity is segment OQe).

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- Similarly, since TC is AC multiplied by quantity, total cost in the above figure is the area of
rectangle bOQeg(Because average cost is segment Ob and quantity is segment OQe).

Therefore, as profit is total revenue (TR) minus total cost (TC), the area of rectangle abgewill be
an excess profit for the firm (i.e., the difference between areas of the earlier two rectangles for
TR and TC).

There are two conditions for equilibrium:

i) MR=MC. This is a necessary condition for profit maximization.

Profit ( )  R  C


0
It is maximum, when Q , because at a maximum point of a curve, first derivative of that
curve (slope) must be zero.

 R C R C
   0  
Q Q Q Q Q  MR  MC

This condition is not a sufficient condition, because there are cases where this equality holds
and yet the firm may not be in equilibrium. Look at the following figure for illustration.

R,C MC

e’ e
MR

Q
Figure 6.6: First Condition of Equilibrium

In the above figure, MR=MC at points e’ and e. But profit is maximum at point e only. That
means we need additional condition for profit maximization.

ii) Slope of MC is greater than slope of MR. This means MC curve cuts MR curve from below.
i.e., MC curve must have a positive slope since the slope of MR is zero. In the above figure, this
condition holds at point e, and not at e’. This second condition is a sufficient condition for profit
maximization.

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Proof of this second condition requires that the second derivation of the profit function be
negative, as follows.

 2  2 R  2C  2 R  2C
0   0  
Q 2 Q 2 Q 2 Q 2 Q 2

2 R  2C
2 2
Here, Q is the slope of MR and Q is the slope of MC. This means the slope of MR is less
than the slope of MC. Since the slope of MR is zero, it is the same as saying the slope of MC is
positive.

The fact that the firm is in equilibrium does not necessarily mean it makes profit. Whether the
firm makes excess profit or loss depends on the level of average total cost curve (ATC) with
respect to price line at the short-run equilibrium. Look at the following figures:

(a) (b) (c)

Figure 6.7: Equilibrium Situations under Perfect Competition

In panel (a) of the above figure, the area of rectangle abge is profit as it is discussed earlier. But
in panel (b) of the above figure, the area of rectangle baeg is a loss. On the other hand, excess
profit is zero for panel (c). The firm in panel (c) is at its break-even, no profit no loss.

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Now, we can say that the firm earns excess profit if average total cost is below price at
equilibrium;

incur a loss if average total cost is above price at equilibrium; and breakeven (no loss no profit)
if average total cost is exactly equal to price at equilibrium.

as long as the loss from staying in a business is less than the loss from shutting down, the firm
will continue to produce, even if it is incurring a loss. This depends on the price level and
minimum average variable cost.

As long as the price per unit sold exceeds the average variable cost per unit produced, the firm
will be covering at least part of its fixed costs. But if price falls below average variable cost, it is
better for the firm to shut down the operation.

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Now, let us introduce average variable cost (AVC) curve.

Figure 6.8: Break-even and Shut-down Points

In the above figure, if price is at P1 the firm's equilibrium is at point B. This point is called break-
even point, no loss no profit point, as it is discussed earlier. But, if price falls to P2, the firm's
equilibrium is at point S. At this point the firm will only cover its variable cost, and hence this
point is called shut-down point. It means that the firm has to shut down its business if price

Supply Curve of a Firm in Perfect Competition: The supply curve of a firm may be derived
from the points of intersection of its MC curve with successive demand curves. Assume that the
market price increases gradually. This causes an upward shift of the demand curve of the firm, as
indicated in panel (a) of Figure 6.9 below.

(a) (b)

Figure 6.9:Derivation of firm’s supply curve

We have discussed that the firm should not produce any level of output if price level is below
minimum average cost curve (below the shut-down point). In panel (a) of the above figure, the
firm will not supply any quantity (will close down) if price falls below P1. If price is at P1, the
level of output to be supplied is Q1. Assume that the market price increases to P2,the firm can
now supply higher level of output at Q2. If price further increases to P3, quantity to be supplied

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will be Q3; and if price is P4, quantity will be Q4, and so on. This implies that the quantity
supplied by the firm increases as price rises.

If we plot the successive points of intersection of MC and the demand curves on a separate graph
we observe that the supply curve of the individual firm is identical to its MC curve to the right of
the closing down point (S), as indicated in panel (b) of the above figure.

6.2.2. Short-run Equilibrium of the Industry

Dear colleague, let us turn to the discussion of industry’s equilibrium. We have seen that the
supply curve of the firm in a perfectly competitive market is its MC curve above shut-down
point. We have also seen that quantity supplied increases as price rises, and hence supply curve
of the firm is an upward sloping curve.

we have said that market supply curve is the horizontal summation of the supply curves of
individual firms. Likewise, the supply curve of a perfectly competitive industry is the horizontal
summation of the supply curves of the individual firms in that industry. This means that the total
quantity supplied in the market at each price level is the sum of the quantities supplied by all
firms at that price. Consequently, the supply curve for the industry will also be an upward
sloping one.

On the other hand, though demand curve for the firm in perfectly competitive market is a
horizontal one, demand curve for the industry is a downward sloping curve.

Given the market demand and the market supply, the industry is in equilibrium at that price
which clears the market. This is at a point where quantity demanded is equal to quantity
supplied. In the following figure, the industry is in equilibrium at price Pe, at which the quantity
supplied and demanded is Qe. However, this will be a short-run equilibrium, if at the prevailing
price, firms are making excess profits or losses. This equilibrium will not stay longer if firms are
making profits or losses because of readjustment process to be discussed in the next section.

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 Figure 6.10: Short-run Equilibrium of a Perfectly Competitive Industry

Activity 6. 5

Why do you think is the demand curve for a perfectly competitive industry not horizontal unlike
the case for demand curve of an individual firm?
______________________________________________________________________________
______________________________________________________________________________
__________________________________________________________________

Section 3: Long-run Equilibrium

Introduction

Dear colleague, in the previous section, we have discussed the short-run equilibrium conditions
for a firm and an industry. In this section, long-run equilibrium conditions will be discussed. We
will start with the long-run equilibrium condition of an individual perfectly competitive firm, and
then discuss the long-run equilibrium conditions of the whole industry.

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Objectives

At the end of this section, you will be able to:

 Explain why firms will only earn normal profits in the long-run;

 Illustrate the conditions for a firm’s long-run equilibrium;

 Discuss the reasons why new firms enter the industry if the existing ones earn positive
profits, and why existing firms exit the industry when they are incurring a loss; and

 Portray that there will not be a further entry or exit at industry’s equilibrium.

6.3.1. Equilibrium of the Firm in the Long-run

In the figure below, assume P1 is short-run equilibrium price of an industry where equilibrium
point is attained at the intersection point of the supply and demand curves. Assume also that a
given firm is making excess profit at that price level. This excess profit, now, is an incentive for
the firm to build new capacity in the long-run so as to produce more and, on the other hand, new
firms will enter the industry attracted by the current excess profit. This expansion of the existing
firms and entrance of new firms will result in an increment of quantity supplied to the market.

Increment in quantity supplied is expressed by rightward shift of the supply curve of an industry
as indicated in panel (a) of Figure 6.11 below. This in turn leads to a reduction in equilibrium
price. This results in reduction of the available excess profit. A fall in the price of output and
reduction in profit will continue until the long-run average cost (LRAC) curve is tangent to the
demand curve of the firm as indicated in panel (b) of the same figure. The long-run equilibrium
of a firm (eL) is at a point where LRAC curve is tangent to the firm’s demand curve. At this point,
there is no excess profit. In the long-run, firms will be earning just normal profits which are
included in LRAC.

Normal profit is the return given to the entrepreneur of the firm for involving himself in the
production of goods and services as opportunity cost.

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 Figure 6.11:Long-run Equilibrium of a Firm in Perfect Competition

Activity 6.6

What do we mean when we say ‘normal profits are included in the long-run average cost’?
Explain?
______________________________________________________________________________
______________________________________________________________________________
__________________________________________________________________

Colleague, we have seen that if there is an economic profit, other firms will enter the industry
attracted by the positive profit. What will the firm do if it incurs a loss? The opposite will
happen.

If a firm is initially incurring a loss in an industry, they will exit from the industry searching for
other profitable ventures. This in turn results in leftward shift of the supply curve. This leads to
an increment in equilibrium price. The loss now starts to decline for the existing firms. A rise in
the price of output and reduction in loss will continue until the long-run average cost (LRAC)
curve is tangent to the demand curve of the firm.

In the long-run, the firm adjusts its plant size so as to produce that level of output at which the
LRAC is the minimum possible. Hence, the condition for long-run equilibrium of the firm is that
the marginal cost be equal to the price and to the long-run average cost as indicated in Figure
6.12 below.

The following equality holds at the firm’s long-run equilibrium:

P = MR = SRMC = SRAC = LRMC = LRAC (Where SR is short-run and LR is long-run)

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 Figure 6.12: Conditions of Firm’s Long-run Equilibrium

We have said, in unit five, that it is possible to vary all inputs in the long-run. Hence, in the long-
run, producers are able to alter their scale of plant. The LRAC or envelope curve is constructed
from a series of short-run periods with different plant sizes. The firm is essentially able to select
the scale of plant associated with the lowest short-run average cost, which coincides with the
lowest point of LRAC curve. The plant size associated with this lowest point of LRAC is called
an optimum and efficient plant size. Hence, long-run equilibrium in perfect competition results
in an optimum allocation of resources.

Generally, in the long-run

a) Firms produce at the minimum of average total cost, that is, they achieve a minimum efficient
scale, and there is no excess capacity.

b) Price equals marginal cost (i.e., P=MC) or incremental cost equals incremental benefit and the
allocation is efficient.

c) There are zero economic profits in the long-run, and firms earn normal profits and not excess
profits.

6.3.2. Equilibrium of the Industry in the Long-run

The industry is in long-run equilibrium when a price is reached at which all firms are in
equilibrium, profits are normal, and all costs are covered. Under these conditions there is no
further incentive for entry or exit, and industry supply remains stable. Since the price in the
market is unique, this implies that all firms in the industry have the same minimum long-run
average cost.

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 UNIT SIX
Monopoly Market Structure

6.1Introduction
Definition of monopoly
Monopoly is quite opposite to perfectly competitive market. And it is defined as: a market
situation in which a single seller sells a product or provides a service for which there is no
close substitute. In monopoly there are no similar products whose prices or sales will influence
the monopolist price or sales. In another words, cross elasticity between monopolist product and
other commodities is zero or low. Since there is a single seller in monopoly market structure, the
firm is at the same time the industry.

Common characteristics of monopoly

Monopoly markets share the following common characteristics.
1. Single seller and many buyers
There is a single seller who sells the product to many buyers.
2. Absence of close substitutes
A product produced by a monopolist has no close substitute so that consumers have no
alternative choices to substitute one product for another.
3. Price maker
In perfectly competitive market, we have said that, both sellers and buyers are price takers.
However, the monopolist is a price maker. Facing a down ward sloped demand curve for its
product, the monopolist can change its product price by changing the quantity of the Product
supplied. For example, the monopolist can increase the price of its product by decreasing the
quantity of supply.
4. Barrier to entry
In monopoly, new competitors cannot freely enter in to the market due to some barriers which
can be economical, technical, legal or other type of barriers.

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6.2 Causes for the emergence of monopoly
Think of any monopoly firm in our country and try to analyze the reason why the firm maintains
its monopoly power. There are many factors that create monopoly and help the monopolists to
maintain monopoly power. Some of the factors will be discussed below.
1. Ownership of strategic or key inputs.
A firm may own or control the entire supply of a raw material required for the production of a
commodity. Such firms are not willing to sell the raw materials to another firm. For example,
until the second world war, the aluminum Company of America, (Aloca) controlled practically
the entire supply of Bauxite(the basic raw material necessary for the production of aluminum),
giving it almost a complete monopoly in the production of aluminum in the united states. To
come to our country, Ambo Mineral Water can be taken as an example. Ambo mineral water has
monopolized the natural mineral water.
2. Exclusive knowledge of production technique.
Most of the beverage (soft drink) companies such as Coca Cola Company have maintained
monopoly power over supply of their product partly due to exclusive knowledge of the
ingredient chemicals required for the production of their product.
3. Patents and copyright
Patents and copyrights are government supported barriers to entry. Patents are granted by the
government for 17 years as an incentive to investors. Authors of books, artistic works (such as
cassette, video, etc) are the best examples of such monopoly. For example, no one, except
AdamaUniversity, can copy and sell this course material as AdamaUniversity has an exclusive
copy right over the material.
4. Government Franchise and License
Another cause for the emergence of monopoly is government franchise. Franchise is a promise
by the government for a firm to prohibit the establishment of another firm (by another person)
that produces the same product or offers the same service as the original one.
For example, when the first Bank in Ethiopia, Abyssinia Bank was established, Emperor Minilik
has promised for the Egyptian firms (the owner of the Bank) that they will monopolize the
Banking service in Ethiopia for 50 years.Postal service in Ethiopia, Ethiopian television,
telecommunication service in Ethiopian etc. are other examples of monopoly.

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5. Economies of scale may operate (i.e. the long run average cost may fall)
Another cause for the emergence of monopoly is economies of scale in production. A firm is said
to have economies of scale if its long run average cost is declining. In such a situation, when the
incumbent firm observes that new firms are entering into the market, it will produce large
amount of output to minimize its unit cost of production and will charge a lower price than the
new firms to deter entry. Such a monopoly is called natural monopoly.
Aside from the few cases of monopoly mentioned above, pure monopoly is rare and most
governments discourage pure monopoly because monopoly is deemed to create inefficiency. For
example, had it been the case that the telecommunication services are not monopolized in our
country, their prices would have been lower. But through pure monopoly is rare, the pure
monopoly model is useful for analyzing situations that approach pure monopoly and for other
types of imperfectly competitive markets (i.e. monopolistic competition and oligopoly)

6.3The demand and revenue curves of the monopoly firm

In the previous unit, we have seen that the perfectly competitive firm is a price taker and faces a
demand curve that is horizontal or infinitely elastic at the price (determined by the intersection of
the industry or market demand and supply) of the commodity. But, remember that the market
demand curve is down ward sloping. However, a monopolist firm is at the same time the industry
and thus, it faces the negatively sloped market (industry) demand curve for the commodity. In
other words, because a monopolist is the sole seller of a commodity, it faces a down ward
sloping demand curve. This means, to sell more units of the commodity, the monopolist must
lower the commodity price.
Conversely, if the monopolist decides to raise the price of the product, it will reduce the quantity
of supply without worrying about the competitors, who by charging lower prices would capture a
large share of the market (customers) at the expense of him. So the monopolist can manipulate
the price of its commodity by changing the quantity of supply. To sell more units of the
commodity, the monopolist will charge lower price and vice versa. Hence, the demand curve
facing the monopolist is negatively sloped, showing the inverse relationship between market
price and quantity demanded.

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 P1

P2

Q
Q1 Q2

Fig.6.1 the demand curve facing the monopolist firm is down wards sloping. At price p1, the firm sells
only Q1 outputs. To sell more units the firm should reduce the price.
Mathematically, assuming that the demand curve is linear, it can be written in the following
form.
P = a – bQ
Where P – is the market price
Q – is the quantity of sales (quantity demanded)
a&b – are any positive constants
The total revenue of the monopolist can be obtained by multiply the market price with the
quantity of sales
That is,
TR = P.Q
Substituting (a – bQ) for P
TR = (a - bQ) Q
TR = aQ – b Q2
Hencethe total revenue curve of the monopolist firm has an inverse U- shape. The total revenue
of a monopolist firm first increases with the quantity of sales (over the elastic range of the
demand curve), reaches its maximum (when the demand curve is unitary elastic), and finally
decreases when quantity of sales increases (over the inelastic range of the demand curve) the
following figure illustrates this fact.

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 P

Ep>1

Ep<1
P1
Ep<1
Q
Q1 DD

TR

TR

Q
Q1

Fig: 6.2 the shape of total revenue curve and its relationship with the price elasticity of demand. When
Ep>1 TR and Q have positive relation, at a point where Ep=1, TR curve reaches its maximum and when
EP<1, TR and Q have negative relation.

The MR curve of monopolist firm is down ward sloping (decreases with quantity of sales). The
fact that the monopolist must lower the price to increase its sales causes the MR to be less than
price except for the first unit. This is so because when the firm reduces the commodity price to
sell one more unit all units which would have been sold at the original higher price will now be
sold at the new (lower) price. The following table may help you better understand this fact.

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Price Quantity TR AR MR
$6 0 0 6 -
5 1 5 5 5
4 2 8 4 3
3 3 9 3 1
2 4 8 2 -1
1 5 5 1 -3

The above table shows that as output increases the TR first increases, reaches its maximum
(when the firm sells the third unit) and then starts to fall.
The MR is less P except for the first unit. For example, when the firm decreases the price from$5
to $4 marginal revenue decreases from $5 to $3. That is, at the second unit MR ($3) is less than
the P ($4).
This is because, when the market price is $5, the firm will sell one unit and will get a TR of $5
and the MR of this first unit is $5. When the price decreases to $4, both the first and the second
unit are sold at $4 and the firm receives total revenue of $8. Now, the MR that the firm obtains
from the second unit is only $3. Hence for a down ward sloping demand curves (in monopoly)
the MR of the firm is less than the market price. Note that the AR of a monopolist is always
identical to the P or demand curve.
In general, the MR curve of a monopolist firm is negatively sloped. The MR will be positive
over the elastic range of the demand curve (because TR is increasing over this range), zero when
the price elasticity of demand is unitary ( because the TR is at its maximum level) and will have
a negative sign over the inelastic range of the demand curve( because TR is decreasing).

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The following figure illustrates the relationship between price elasticity of demand and MR

Ep>1

Ep=1

P1
Ep<1

DD

MR
Fig: 6.3 the relationship between MR and P. The MR of a monopolist lies below the commodity price for
each unit sold (except the first unit) and it is negative over the inelastic range of the demand curve.
Mathematically, it can be shown that MR is less (steeper) than the AR or demand curve.
Suppose a monopolist’s demand curve is given by
P = a – bQ
Where a&b - are any positive constants
P&Q – are price and quantity.

TR = P.Q = (a - bQ) Q
= aQ – bQ2
By definition MR is change in TR that happens due to a one unit change in quantity of sales.
Symbolically,
dTR d (aQ  bQ 2)
MR   a  2bQ
dQ dQ

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Thus, MR = (a – 2bQ) has a slope which equals twice the slope of demand (average revenue)
curves. This implies that MR is less than AR or demand or price.
Dear learner, we have seen that a monopolist firm faces a down ward sloping demand curve.
Exception to the law of demand under monopoly is that the firm can increase the quantity of
sales only through promotional activities (with out price cut).

Profit maximization in the short run

Dear learner, do you remember how a perfectly competitive firm maximizes its profit? In this
section, we examine the determination of equilibrium price and output by a monopolist in the
short run. We will also show that a monopolist, like a perfectly competitive firm, can incur
losses in the short run. Finally, we demonstrate that, unlike the case of the perfectly competitive
firm, the monopolist’s short run supply curve can not be derived from its short run marginal cost
curve (the supply curve of the monopolist is indeterminate).
To start with, it was discussed in the last chapter that in a perfectly competitive market price is
given and profit maximization involves only looking for the profit maximizing unit of output,
given the market price. But, under monopoly, the firm is a price maker and has a power to alter
the level of output. Thus, profit maximization under monopoly involves determination of the
price and output combination that yields the firm the maximum possible profit.

Price and output combination that maximizes the monopolist profit can be determined in the
similar fashion as that of the perfectly competitive firm. That is, price- output combination that
yields the monopolist the maximum profit can be determined in two ways:
1. Total approach
2. Marginal approach
Now let us see the two approaches one by one.

1. Total approach
In this approach the profit maximizing unit of output is defined as that level of output where the
positive difference between TR and TC is maximal or the negative difference between TR and

212
 TC is minima. The equilibrium price can be determined by dividing the TR corresponding to the
equilibrium output level to the equilibrium output. The following figure tells more about this
approach.

TR, TC
TC

TR*

TR

PROFIT
Q
Q1 Q2 Q3

Q
Q1 Q2 Q3

MR

Fig 6.3 Short –run equilibrium of the monopolist Total approach: The TR of the monopolist has an
inverse U shape because the monopolist must lower the commodity price to sell additional units. The
STC has the usual shape. The total profit is maximized at Q2, where the positive difference between the
TR and STC is the greatest.Profit is negative for output levels below Q1 and above Q .In this approach
the profit maximizing price is given by the ratio of TR* to Q2.

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 2. Marginal approach
In this approach the profit maximizing level of out put is that level of out put at which marginal
cost curve cuts the marginal revenue curve from below. The equilibrium (profit maximum) price
is the price corresponding to the equilibrium price from the demand curve.

Consider the following figure:

a
P1

P2 SMC
d
P3

b
E
c
DD or AR

Q1 Q2 Q3
MR

Fig. 6.4 Short- run equilibrium of the monopolist: marginal approach. Equilibrium output is Q2, where
MC and MR curves intersect each other and MC curve is up ward sloping. Equilibrium price is the price
corresponding to the equilibrium quantity, Q2 (i.e. p2).

Note that, a monopolist charges a price which exceeds the MC of production, unlike the case of
the perfectly competitive firm. Now, how can we be sure that Q 2 is the profit maximizing unit of
out put? To answer this question, note that in the total approach the level of profit at a given
level of output is the vertical distance between the TR and TC (i.e, ∏ = TR - TC.)

In the marginal approach, however, the level of profit at a given level of output is not the
distance between the MR and MC curves. Rather it is the area between marginal revenue and
marginal cost curves starting from the origin up to the given level of output. Symbolically, the
level of profit say at Q2 level of output is:

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∏at Q2 = TR at Q2 – TC at Q2 ---------------------------- Total approach
Q2

(MR  MC )dQ
∏at Q2 = 0 ------------------------- Marginal approach

Given the level of profit as the area between the MR and MC, let’s come back to our question
above.

In the above figure, we have said that the equilibrium price is Q2 and the level of profit is the
area between that part of MR and Mc curves between the origin and Q2 (area abE).
Now we are going to prove whether this level of output is actually the profit maximizing level of
output. To prove this, suppose initially that the monopolist produces a smaller quantity Q1 and
receives the higher price, P1. The level of profit at this level of output the area between that part
of MR and MC curves ranging from the origin up to Q1 ( i.e. area abcd). Hence the firm loses
the level of profit given by the area cde by producing Q1 level of output instead of Q2.Thus, any
level of output below Q2 can not yield the firm the maximum profit. Similarly, it can be shown
in the same way that any level of output above Q2 can not maximize the firm’s profit.

In other words, for any level of output below Q2, MR is greater than the MC, implying that each
additional unit of output yields larger additional (marginal) revenue to the firm than the
additional cost of producing it. Hence the firm should produce additional units until Q2. On the
other hand, for all levels of output above Q2, the MC of producing additional unit of output is
greater than the MR obtained from it. Hence, the firm should not expand its output above Q2.
This argument can prove the fact that Q2 is the profit maximizing level of output.

Mathematically, the profit maximizing condition of MR = MC and MC is increasing can be

shown as follows.
∏ = TR – TC
∏ is maximized when d
0
dQ
D dTR dTC
  0
dQ dQ dQ

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That is,

 MR – MC = 0
 MR = MC ………………………….. first order condition
The second order condition of profit maximization is

That: d 2
0
dQ 2

That is, d 2 d 2TR d 2TC

  0
dQ 2 dQ 2 dQ 2  dTR 
d  
2
d TR  dQ  dMR
dMR dMC  
  0 (Because dQ 2 dQ dQ and the same for MC)
dQ dQ

Slope of MR- slope of MC<0

Slope of MC > slope of MR ------- the second order condition

Numerical example

Suppose the monopolist faces a market demand function given by P=40-Q. The firm has a fixed
cost of $ 50 and its variable cost is given as TVC=Q2 determine:
a) the profit maximizing unit of output and price
b) the maximum profit
Solution
Given: p=40-Q
TFC=50
TVC= Q2
a) equilibrium condition is MR=MC, and slope of MC>slope of MR.

TR=P.Q = (40-Q) Q =40Q- Q2

TC=TFC+TVC =50 + Q2

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Now, dTR d (400  Q 2 )
MR   40  2Q
dQ dQ

dTC d (50  Q 2 )
MC   2Q
dQ dQ

MR=MC 40-2Q=2Q
40=4Q
Q=10

dTR
Second order condition: slope of MR   2
dQ

dMC
Slope of MC  2
dQ

dMC dMR The second order condition is met


dQ dQ

Thus, the profit maximizing level of output is10 and the profit maximizing price is
obtained by substituting the profit maximizing quantity (10) in the demand function.
Thus, P = 40 – Q
P = 40 – 10 = 30
b) The maximum profit is the level of profit obtained from selling 10 units at $ 30 each.
∏ = TR – TC
But TR = P.Q
= $ 30 * 10 = $ 300
TC = 50 + Q2 = 50 + 102 = $ 150
The maximum ∏ is thus $ 300 - $ 150 = $ 150.

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Exercise:
144
Q 2
Suppose the monopolist faces the market demand function given by P .The AVC of the
firm is given as AVC = Q ½ and the firm has a fixed cost of $ 5

a) determine equilibrium P&Q

b) determine the maximum profit
6.6 Absence of unique supply Curve under Monopoly

Under Perfect competition, you remember that firms have unique supply curve. That is there is
unique supply price for each unit of output supplied. In monopoly supply price is not unique. A
given quantity could be supplied at different prices and different quantities can be sold at the
same price, depending on market demand and marginal revenue. Hence there is no one to one
P . Consider the following figures.
correspondence between P and Q under monopoly
P
Fig.6.5

MC

MC
P1 P E1
P
E2
D D1

D D1 MR1
Q Q Q1 Q
MR
Q* MR1 MR

Panel-1
In this panel, the same quantity Q* is sold at Panel-2
different prices depending on the market In this panel, initially equilibrium is E1
demand. If the market demand is D1 and the MR (where MR1=MC) and equilibrium P&Q1.
curve is MR1, equilibrium occurs when MR1 when the demand for monopolist product
cuts MC curve and the equilibrium price and decreases to D the new equilibrium
quantity are P1 and Q*. If the market demand becomes E2 where the new MR=MC At
for the monopolist product decreases to D, the the new equilibrium, price is the same, but
monopolist can still sell the same quantity Q* by the monopolist sell only Q amount of
lowering the price. So, there is no unique (or output i.e. the monopolist sells lower
one to one correspondence) between P&Q, as quantity at the original price when the dd
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the same Q* is matched with two different price, decreases.
P&P1
 Therefore, there is no unique supply curve under monopoly.

6.7 Long – run Equilibrium under Monopoly

The monopolist’s long run condition is different from the perfectly competitive firms’ long run
situation in respect of the entry of new firms into an industry. In perfectly competitive market
there is free entry in the long run. Nevertheless, entrance is barred by several factors in
monopoly. More over, we have seen that a perfectly competitive firm can earn only normal profit
in the long run. The monopolist firm can, however, get a positive profit even in the long run
because there are entry barriers that discourage new firms to enter the industry, attracted by the
positive profit.

Let us now examine the long run equilibrium situation for single plant monopolist. If the
monopolist incur loss in the short run (SAC>P) and if there is no plant size that will result in
super normal profit in the long run given the market size, the monopolist must stop operation
(shut down). If the monopolist makes (P> SAC) in the short run in a given plant, the monopolist
not only continue its operation but also looks for different plant size to expand, so that could
maximize profit in the long run. But at what output level the monopolist maximizes its profit? A
monopolist maximizes its long run profit when it produces and sells that output level where
LMC = MR , slope of LMC being greater than the slope of MR at the point of intersection, and
the optimal plant size is the one whose SAC curve is tangent to the LAC at the point
corresponding to long run equilibrium output.

219
 Let’s illustrate the equilibrium situation graphically.

SMC1
P1
C SAC1 LAC

SMC2 LMC

Pe SAC2

MR
DD

Q
Q1 QE

Fig 6.6Suppose initially the monopolist builds the plant size having the costs SAC1 and SMC1 the
equivalence of SMC1 and MR leads into producing and marketing output levels Q1 and P1, making a unit
profit of P1 – C, since the monopolist is making a positive profit, it decide to continue its operation and
looks for a more profitable plant size in the long run. This long run plant is attained when LMC = MR,
and the corresponding output level and price are Qe and Pe respectively.

Finally, it should be noted that there is no certainty in the long run that the monopolist will reach
the optimal plant size (minimum LAC), as in perfectly competitive case. The monopolist may

220
reach optimal plant size or even may exceed the optimal size if the market demand allows him
(or if there is enough demand which absorb that level of output).

6.8 Monopoly Power

Pure monopoly is rare. It is common to see market in which several firms compete with one
another. Although many firms compete with one another some firms may have greater monopoly
power than the others. Hence they can affect the market price more than other firms. You may
think that firms which share the larger part of the market supply have greater monopoly power.
But this can not be necessarily true. What matters is the consumers’ preference for the firm’s
product. If most consumers prefer the product of the firm to other substitutes, the firm has greater
monopoly power than other firms in the market and the firm can slightly increase the price of his
commodity being confident that he will not lose its customers.

Now let us come to discuss measurement of monopoly power. The important distinction between
a perfectly competitive firm and a monopolist is that: for the competitive firm price equals
marginal cost; and for the firm with some monopoly power price exceeds marginal cost.
Therefore, a natural way to measure a monopoly power is to examine the extent to which the
profit maximizing price exceeds marginal cost. In particular, we can use the mark up ratio of
price minus marginal cost to price that we introduced earlier. This measure of monopoly power,
introduced by an Economist Abba Lerner in 1934, is called Lerner index of monopoly power.
Lerner index (L) is the difference between price and marginal cost, divided by price.
Symbolically, L = P – MC L - is learner index of monopoly power
P
L always has a value between zero and one. For perfectly competitive firm, P = MC, so that L =
0 i.e. there is no monopoly power in perfect competition. Hence, the larger L is the greater the
degree of monopoly power.

The learner index of monopoly power (L) can also be expressed in terms the price elasticity of
demand for the firm’s product as follows.

221
 1 dQ P
L ep  .
ep , where dP Q and /Ep/>1, since the monopolist operates only over the elastic
range of its demand curve.

Proof: From the mark-up pricing, we know that

MC
P
1
1
ep
Re arranging this we get
1 MC
1 
ep P
1 MC
 1
ep P

1 MC  P

ep P
1 P  MC
 
ep P
P  MC
But, P is the learner index of monopoly power (L),
1
L
Thus, ep

6.9 The multi- plant monopolist

We have seen that a monopolist maximizes its profit by producing that level of output where MR
equals MC. For many firms, however, production takes place in two or more different plants
whose operating costs can differ. To minimize transport cost, to approach the consumers or for
different reasons a monopolist may establish more than one plant in different areas. The
operating costs of these plants can also vary due to many reasons such as variation in prices of
raw materials, wage of labors etc. Now let's examine how a monopolist facing such cases

222
maximizes its profit by taking the following a two- plant monopoly firm as an example. Data
regarding cost and revenue is given in a table below.

Out put and sales P r i c e Marginal revenue Marginal cost Marginal cost Multi plant
Plant -1 Plant-2 Marginal cost
1 5 . 0 - 1 . 9 2 2 . 0 4 1 . 9 2
2 4 . 5 4 2 . 0 0 2 . 1 4 2 . 0 0
3 4 . 1 3 . 3 0 2 . 0 8 2 . 2 4 2 . 0 4
4 3 . 8 2 . 9 2 . 1 6 2 . 3 4 2 . 0 8
5 3 . 5 5 2 . 5 5 2 . 2 4 2 . 4 4 2 . 1 4
6 3 . 3 5 2 . 3 5 2 . 3 2 2 . 5 4 2 . 1 6
7 3 . 2 2 . 3 0 2 . 4 0 2 . 6 4 2 . 2 4
8 3 . 0 8 2 . 2 4 2 . 4 8 2 . 7 4 2 . 2 4
9 2 . 9 8 2 . 1 8 2 . 5 6 2 . 8 4 2 . 3 2
1 0 2 . 9 8 2 . 0 8 2 . 6 4 2 . 9 4 2 . 3 4

Given this information, how can the monopolist decide the total production and how much of
that output each plant should produce?

The logic used in choosing output levels is very similar to that of the single-plant firm. We can
find the answer intuitively in two steps.

Step 1 - What ever the total output, it should be divided between the two plants so that marginal
cost is the same in each plant. Other wise, the firm could reduce its cost by reallocating
production. For example, if marginal cost at Plant-1 were higher than at Plant-2, the firm could
produce the same output at a lower total cost by producing less output at plant -1 and more
output at plant-2. Thus, for equilibrium to occur marginal cost at firm-1 (MC 1) must equal
marginal cost at firm- 2 (MC2) i.e. MC1 = MC2

Step-2 We know that the total output must be such that marginal revenue equals the multi plant
marginal cost. Now it is essential to know first how the multi -plant marginal cost is derived

223
from each plant marginal costs. If the firm wants to produce the first unit, it should produce it in
plant 1 because, the MC is lower in plant 1 than in plant 2 (i.e. 1.92 < 2.04). Hence, MC of
producing the first unit for the multi –plant monopolist is 1.92. If output is to be two units or if
the firm wants to add one more units, the second unit should also be produced in plant 1 because
the MC of the second unit in plant 1 is less than MC of producing one unit in plant 2 (i.e. 2.00 <
2.04). Hence, multi-plant marginal cost for the second unit is $2. If three units are to be
produced, plant 2 will enter into production since the MC of producing one unit in plant 2 (2.04)
is less than marginal cost of producing the third unit in plant 1, & 2.08.

Hence, multi-plant MC for the third unit is 2.04, the derivation of multi-plant marginal cost
continues in the same manner.
Once, multi-plant marginal cost is derived, the only thing left to obtain equilibrium total output is
equating the multi plant MC with the marginal revenue. So in the above table, equilibrium output
is 8 units where MC of multi-plant = Marginal revenue (i.e. 2.24 = 2.24).

Now the remaining issue will be how to allocate the total production between plants 1 and 2. The
multi plant monopolist allocates production in a way that each plants MC equals common value
of multi plant MC and marginal revenue. The common value of multi plant MC and marginal
revenue is 2.24. Thus it follows that the allocation of production is in a way that MC of plant-1 =
2.24 and MC of plant-2 = 2.24
i.e. Plant 1 produces 5 Units (because at 5 units MC1 = 2.24)
Plant 2 produces 3 units (because at 3 units MC2 = 2.24)
In short, the condition of equilibrium in multi- plant monopolist is: MR = MC of multi plant
monopolist and to allocate the total out put among each plant, the condition must satisfy:
MC1 = MR = MC of multi plant monopolist
MC2 = MR = MC of multi plant monopolist
MR = MC1 =MC2
Graphically, the above table (problem) can be represented as follows
P, MC, MR

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 MC1 MC. Multi plant
MC2

P
D=AR

MCa
E

3 5 8 Q

Fig 5.7 Multi-plant monopolist equilibrium. MC 1 and MC2 denote the MCs of production in plants 1&2
respectively. MCm denotes the marginal cost of multi-plant firm which is derived from MC 1 and MC2.
Note that, MCm is obtained from MC1 and MC2 by adding the levels of out put produced in the two plants
at equal marginal costs. E.g. when marginal cost is MCa, the firm produces 3 units in plant 1 and 5 units
in plant 2 and the monopolist marginal cost of producing the 8 th unit is MCa. The Multiplan monopolist’s
equilibrium is defined by point E and the two firms 1and2 produce 5 and 3 units respectively.
Now let us derive this rule algebraically,
Let Q1 and C1 be the output and production cost of plant1 and C1 = f (Q1)
-Q2 and C2 be the output and production cost of plant-2 and C2 = f (Q2) and
- QT = Q1 + Q2 is the total output of the firm.
All output, whether they are produced in plant 1 or in plant2 will be sold at uniform market price,
Say P then the total profit of the monopolist is 6
p = P. QT – C1 – C2
p = PQ1 + PQ2 – C1 –C2,
d d
and
To maximize profit dQ1 dQ2 must be equal to zero

225
p = TR – C1 – C2 , because PQ1 + PQ2 = TR the condition of equilibrium is:
d dTR dC1 dC 2
   0
dQ1 dQ1 dQ1 dQ 2 ž MR1 - MC1 = 0
d dTR dC1 dC 2
   0
dQ 2 dQ 2 dQ 2 dQ 2 ž MR2- MC2= 0
Note that:
dC 2
0
dQ1 Because C2 = f (Q2) and
dC1
0
dQ 2 Because C1 = f (Q1)
The equilibrium condition is, thus
MR1 = MC1
MR2 = MC2
But MR1 = MR2 because all outputs whether they are produced in plant1 or plant 2 are sold at
the same market price.
Let MR1 = MR2 = MR
Then the above equilibrium condition can be written as:
MR = MC1 and
MR = MC2
Equivalently, it can be written as MR = MC1 = MC2

Now let us see one numerical example

Suppose Ethiopian Electric Light and Power Corporation (EELPC) is a multi-plant monopolist
having two plants, abay plant (plant1) and Fincha plant (Plant2). The operating costs of the two
plants are given as follows:
Abay Plant: TC1 = 10 Q12 and where Q1 - Amount of electric power produced in bay
Fincha plant: TC2 = 20 Q22 Q2 – amount of electric power produced in Fincha

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EELPC estimates the demand for electric power by the following function

P= 700 – 5Q where P - is price (total in million birr) per Giga watt and
Q – Is the total amount of Giga watt sold and Q = Q1 + Q2
Note that a Giga watt of electric power, whether it comes from Fincha or abay plant worth equal
price
a) What level of output (electric power) should EELPC produce and what price per Kilowatt
should it charge to maximize its profit?
b) How much of the total output should be produced in each plant?
c) Suppose that recently the abay plant is suffering from siltation problem (which leads to
additional cost of cleaning the dum), but Fincha plant is not. How should EELPC adjust Q1, Q2
and QT and P to maximize its profit?
Solution
a) The equilibrium condition is:
MR = MC1
MR = MC2
TR = P.Q
= (700 – 5Q) Q = 700Q-5Q2

dTR
MR = dQ = 700- 10Q, where Q = Q1+Q2
Thus, MR = 700 – 10 Q1 – 10 Q2

dTC1
20Q1
MC1 = dQ2

dTC 2
MC2 = dQ2 = 40 Q2

Now the equilibrium occurs when:

227
 700 – 10Q1- 10Q2 = 20Q1 and
700 – 10Q1 – 10Q2 = 40Q2
Re-arranging the above equations we get the following simultaneous equation.
30Q1 + 10Q2 = 700
10Q1 + 50Q2 = 700
Solving the above equations simultaneously, we get
Q1 = 20 giga watts
Q2 = 10 giga watts
The profit maximizing level of output is, thus, Q1+Q2
= 30 giga watt
To determine the equilibrium price we substitute the total output (30) in the demand function:
Accordingly, P = 700 – B (30)
= 550 mill birr
b) The Tekeze plant should produce 20 giga watts and the Fincha plant should produce 10 giga
watts
c) To answer this question let us graphically present the problem. In the following figure suppose
MC1, MC2 and MCm denote the initial marginal cost of Tekeze, Fincha and the multi-plant
(EELPC), and MCm denote the new marginal costs. Note that the silt problem will increase the
MC1 to MC1’ and as a result MCM will increase to MCM’.

MC2
MC1’

MC1 MCm’

PT
MCm

550

E2

E1

D=AR
MR

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 10 Q2 Q1 20 20 QT 30

Fig.6.5
Initially, the total output was 30 giga watts.out of which, 20 gw is produced in Tekeze and 10gw
in Fincha.
Due to siltation problem MC1 shifts up ward to MC1' and MCm shifts up ward to MCm'. The
new equilibrium takes place at E 2 i.e. the total output decreases from 30 to Q T, output of Tekeze
plant decreases from 20 to Q1.
And that of Fincha increases from 10 to Q 2. Hence the firm will re allocate some of its output
from Tekeze to Fincha and will decrease the total output from Tekeze to Fincha
And will decrease the total output. As to equilibrium price is concerned, it increases from 550 to
PT.
6.10 Price Discrimination
Price discrimination refers to the charging of different prices for the same good. But not all price
differences are price discrimination. If the costs of offering a certain uniform commodity
(service) to different group of customers are different (say due to difference in transport costs),
price of the commodity may differ for each group owing to this cost difference. But this can not
be considered as price discrimination. A firm is said to be price discriminating if it is charging
different prices for the same commodity with out any justification of cost differences.
By practicing price discrimination, the monopolist can increase its total revenue and profits.
Necessary conditions for price discrimination
For a firm to effectively practice price discrimination the following necessary conditions should
be fulfilled.
1-There should be effective separation of markets for different classes of consumers, so that
buyers of low price market cannot resale the commodity in high price market.
A market is said to be effectively separated if one of the following points is met:
- Geographical variation with high transport cost so that the inter market price margin is unable
to cover the transport expense.
E.g. Domestic Vs international markets.
- Exclusive use of the commodity. For some services resale is inherently difficult. For example
you cannot resale Doctor’s services, Entertainment shows.

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- Lack of distribution channels
2. The second necessary condition to successfully practice price discrimination is that the price
elasticity of demand should be different in each sub market.
For example, a movie theatre knows that college students and old people differ in their
willingness to pay for a ticket and can exercise discrimination by charging the college students a
higher price. This condition can be justified by using the markup formula. Suppose the firm has a
marginal cost of MC and the price elasticity’s of demand for its product into different markets
are ed1 and ed2
Then the price in each market is
MC MC
P1  , and .P 2 
1 1
1 1
ed1 ed 2
If ed1= ed2, P1 will be automatically equal to P2.
Hence, ed1 = ed2 for the prices to differ.
3- Lastly, the market should be imperfectly competitive. In other words, the seller of the product
should have some monopoly power (it should not be price taker) to practice price discrimination.

6.11Degrees (types) of price discrimination

The degree of price discrimination refers to the extent to which a seller can divide the market and
can take advantage of it in extracting the consumer Surplus. In economics literature, there are
three degrees of price discrimination. These are discussed one by one here under.
1. First degree price discrimination (Perfect price discrimination)
This is a price discrimination in which the monopolist attempts to entirely take away the
consumers surplus. Ideally, a firm would like to charge each customer the maximum price that
the customer is writing to pay for each unit bought. We call this maximum price the consumer’s
reservation price and obviously, the consumers’ reservation prices are different due to the
differences in their economic status or the value they attach to a commodity. The practice of
charging each customer his/her reservation price is called first degree price discrimination. Note
that the consumer’s willingness to pay reservation price for a given commodity varies with the
quantities of the commodity the consumers own. The law of diminishing marginal utility implies
that a consumer’s willingness to pay for successive units of a commodity declines because the

230
marginal utilities of these successive units decline. Hence, in the first degree price discrimination
prices differ across customers, and a given customer may pay more for the initial units than for
others (successive units).
First degree price discrimination is the limiting case of price discrimination, the monopolist, in
this case, individually negotiate with each buyer and sell each unit of the output at the
corresponding price given on the demand curve of the consumer, then receiving the entire of
consumer’s surplus.
For example, a doctor who knows his patients’ paying capacity charges high price for the
richest patients’ and low price for the poor patients for identical services.
This is practiced to increase revenue. If the doctor fixes the price at the richest patients’
level, no poor will afford to pay and the doctor will not get revenue from the poor. On the
other hand, the doctor would not fix the price at the poorest patients’ level for all patients
because he knows that the rich can pay more and he will exploit the rich. Lawyers also
practice the same discrimination for identical legal service.
Perfect price discrimination is efficient as it maximizes the total welfare, where welfare is
defined as the sum of consumer surplus and producer surplus. That is, there is no welfare loss
associated with first degree price discrimination equilibrium. The problem with perfect price
discrimination is that it hurts consumers because the monopolist will take the entire of the
consumer surplus. The other problem with perfect discrimination is that it involves high
transaction costs; it is too difficult and costly to gather information about each customer’s price
sensitively.

2. Second degree price discrimination (block pricing)

Many firms are unable to determine which customers have the highest reservation prices. Such
firms may know, however, that most customers are willing to pay more for the first unit than for
successive units. This is due to the fact the typical customer’s demand curve is down ward
sloping. Such a firm can price discriminate by letting the price each customer pays vary with the
number of units the customer buys. The act of charging different prices for different quantities of
purchases is called second degree price discrimination or some times called quantity
discrimination. In second degree price discrimination the price various only with quantity: all
customers pay the same price for a given quantity.

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In second degree price discrimination, the monopolist attempts to take the major part of the
consumer surplus instead of the entire of it.
Block pricing can feasibly be implemented where:
-the number of consumers is large and price rationing can be effective e.g.Electricity and
telephone services.
-the demand curves of all customers are identical and
-a single rate is applicable for a large number of buyers.
Graphically, block pricing can be explained as follows:
A monopolist that practices second degree price discrimination charges the price OP1, for the
first OQ, units, OP2 for the next Q1 Q2 units and OP3 for Q2 Q3 units. By doing so, the
monopolist will increase its total revenue by extracting the major part the consumer surplus.

P1

P2

P3
DD

Q1 Q2 Q3

Fig.6.7 Second price degree price discrimination. The monopolist receives a price OP1, for each unit
sold to a given customer for the first OQ, units, OP2 for the next Q1 Q2 units and OP3 for the next Q2 Q3
units. By so doing, the monopolist will receive total revenue of OP, A B C D E. If the monopolist charges
a uniform price of OP3, its total revenue will only be OP3 EQ3. Hence, block pricing will enable him
receive large total revenue than uniform pricing.

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Note that not all quantity discounts are a form of price discrimination. Some times selling in
large quantities may reduce the unit costs of sales and as a result a firm may charge a relatively
lower per unit price for large sales than small sales. Such an action cannot be regarded as price
discrimination.
3.Third degree price discrimination (multi-market price discrimination)
Typically, a firm does not know the reservation price for each of its customers. But, the firm may
know which groups of customers are likely to have higher reservation prices than others. In such
a situation the firm may divide potential customers in to two or more groups and set a different
price for each group. Such an action of charging different prices in different markets is called
third degree price discrimination. All units of the good sold to customer with in a group (in one
market) are sold at a single price, but prices will differ among the different groups or markets.

For simplicity, let us assume that there are only two markets. To maximize profits, the
monopolist must produce the level of out put (defined by MC=MR) and sell that out put in the
two markets in such away that the marginal revenue of the last unit sold in each market is the
same. This will require the monopolist to sell the commodity at higher p rice in the market with
the less elastic demand.

For example, suppose that a monopolist has 100 units of a commodity to be sold in one or both
of two sub markets. How should the monopolist allocate the 100 units between the two markets
to maximize its profit? Suppose, initially, that the monopolist simply sold 50 units in each
market and also assume that the marginal revenue of the last unit sold in market 1 is 5 and the
marginal revenue of the last unit sold in market 2 is 3.

In this case, the monopolist can increase its total revenue by decreasing the number of units sold
in market 2 and increasing the number of units sold in market 1. Hence, if one less unit is sold in
market 2, total revenue falls by $3. But by selling this unit in market 1 total revenue increases by
$5.So, by reallocating it sales from market 2 to market 1 the monopolist can increase its total
revenue by $2 ($5-3$). Obviously, reallocation of sales will increase the firm’s total revenue
until the marginal revenue of the last unit sold in each market gets equal.

233
Thus we can conclude that to maximize the total revenue received from the sale of a given
quantity a commodity, the monopolist should allocate the total quantity in each sub market in
such away that the marginal revenue of the last unit sold in each sub market is the same.
Symbolically, the equilibrium condition for a third degree price discriminating monopolist is:
MC=MR1=MR2.

Now let us drive this equilibrium condition algebraically.

Assume that the firm sells its product in two markets and the demand functions of the segmented
markets are given as:
P1= f1 (Q1) and p2= f2 (Q2)
And suppose that cost function of the firm is
TC = f (Q), where Q=Q1+Q2
Q1 is the amount of the commodity sold in market 1
Q2 is the amount sold in market 2.
The total profits of the monopolist (∏) are equal to the total revenue it receives from selling the
commodity in the two markets (i.e., TR1 + TR2)minus the total cost of producing the total out
put (TC),that is,
п=TR1+TR2-TC---------------------------- (1)
But TR1=P1.Q1 and TR2 =P2. Q2
For ∏ to be maximized, the first derivatives of the ∏ function with respect to Q1 and Q2 should
be equal to zero. That is,

 
 0
Q1 Q2 -------------------------- --------------- (2)
 TR1 TR 2 TC
0    0
But, Q1 Q1 Q 2 Q1 -------------------- (3)

MR1- MC1=0 or MR1 = MC1

 TR1 TR 2 TC
0    0
and Q 2 Q 2 Q 2 Q 2 -------------------- (4)

234
ž MR2 – MC2 = O or MR2 = MC2
Note that:
TR 2
0
Q1 In equation (3) because TR2 is only a function of Q2.
TR1
0
And Q 1 in equation (4) because TR1 is only a function of Q1.
Now the equilibrium condition equation (2) & (4) can be summarized as.
MR1==MC1
MR2==MC2--------------------------------------------- (5)
But, note that the monopolist produce its commodity in one plant, and the fact that the
commodity is sold in market 1 or market 2 has no impact on the marginal cost of the commodity
(i.e., MC1==MC2)
Suppose—that MC1 =MC2 =MC
The equilibrium condition equation (5) can be reduced
In to MR1= MC
MR2=MC
Or MR1= MR2 =MC------------------------------------------- (6)
Thus, the equilibrium condition of a third degree price discriminating monopolist is MR=MR2
=MC.

Numerical example

Suppose a monopolist sells its commodity in U.S.A and Ethiopian markets. The demand function
for the monopolist’s product in U.S.A market is given as Pu=100-Qu and in Ethiopian market the
demand function is Pe=80-2Qe, where Pu and Qu denote price and quantity demanded in U.S A
and PeandQe denote price and quantity demanded in Ethiopia.
The monopolist has 55 units of the commodity.
a) How many units should be sold in Ethiopia and U.S.A?
b) In which country should the firm charge larger price? Why?

235
Solutions
a) the monopolist allocates its product in such a why that MRu= MRe
TRu T Re
, and , M Re 
MRu = Qu Qe

But, TRu = Pu.Qu

=(100-Qu) Qu = 100 Qu- Qu2 and
TRe = Pe. Qe
=(80-2Qe)Qe =80Qe-2Qe2

MRu 

d 100Qu  Qu 2 
dQu =100-2Qu and

M Re 

d 100Qe  Qe 2
dQe )= 80 - 4Qe
The Firm maximizes its revenue when the condition MRu=MRe is fulfilled. That is, it maximizes
its revenue when:
100 -2 Qu =80-4Qe or
2Qu – 4 Qe =20--------------------------- (1
Moreover, we know that Qu + Qe = 55------------------ (2)
Solving equations (1) and (2) simultaneously, we obtain Qu= 40 units and Qe =15 units.
Thus, the monopolist should sell 40 units in U.S.A and 15 units in Ethiopia to maximize its TR,
the demand functions in each country.
Pu = 100 –Qu
Substituting 15 for Qe, we get Pe =$ 50
Hence, the firm should charge higher price in U.S.A. the reason is that the price elasticity of
demand for the firm’s commodity is lower in U.S.A than Ethiopia.
That is,
Price elasticity of demand in U.S.A (Eu) is

dQu Pu
Eu  .
dPu Qu

236
 = -1* 60/40 = /-3/2/ = 1.5

And price elasticity of demand in Ethiopia (i.e.) is

dQe Pe
Ee  .
dPe Qe

= -1 . 50/2 = / -50/2/ =1. 67

Eu<Ee which implies that a one percent increase in price of the commodity reduces the
amount of sales by a lower percent(1.5%) in U.S.A than in Ethiopia (1.67%).In other words,
U.S.A.citizens are less sensitive to a price change than Ethiopians so that the firm can charge
higher price in U.S.A.

The fact that the firm should charge a higher price in the market having lower price elasticity of
demand can be shown algebraically as follows:
You know that the marginal revenues in two markets (market1 and 2) having price elastic ties of
demand, Ed1 and Ed2 respectively are given as:

 1 
MR1  P1 1  
 Ed1  Where MR1 and P1 are marginal revenue and price in market 1

 1 
MR 2  P 2 1  
 Ed 2  Where MR2 and P2 are marginal revenue and price in market2

For optimal allocation of the commodity between the two markets, Mr, = MR2 i.e.,

 1   1 
P1 1    P 2 1  
 Ed1   Ed 2 

Or

237
 1
1
P1
 Ed 2
P2 1
1
Ed1
1
1
Ed 2
1
1
If /ed2/ > /ed,/the ratio Ed1 will be greater than one (i.e 1+1ed2>1), which implies
that P1/P2will be greater than one (i.e, P1/P2>1)
Therefore, if /Ed2/>/Ed1/, P1>P2

Hence, the larger the price elasticity of demanded, the lower the price to be charged.

Numerical example

Suppose Ethiopian Airlines (EAL) flies only one route: from Addis Ababa to Dubai. EAL knows
that two different types of people fly to Dubai. Type A consists of rich merchants flying to Dubai
for business purposes with demand for flight of
QA = 260-0.4PA. Type B consists of poor ladies flying to Dubai in search of jobs ( such as
house maid) whose total demand is QB = 240-0.6PB.

Assume that EAL has a running cost of $30,000 plus $100 per passenger and it has decided to
charge different prices for the two groups of passengers.
a. How many tickets should EAL sell to each group?
b. How much price should EAL charge each group?
c. Suppose now that EAL is prohibited by the Ethiopian government to exercise such
discrimination. How many tickets should the EAL sell to maximize its profit and at what price?
Solution
Given
TC = 30,000 + 100Q
Where Q = QA+QB
QA = 260 – 0.4PA …………………………….Merchants demand function:

238
 PA = 650 – 2.5QA
QB = 240 – 0.6 PB…………………………..Ladies demand function
5
PB 400  QB
3
a) The equilibrium condition is that
MC=MRA = MRB
dTC
100
But MC = dQ

dTRA
, and 2
MRA = dQA TRA = QA.PA = 650QA – 2.5 Q A
Thus, MRA= 650 – 5QA
10
QB
Likewise MRB = 400 - 3
The equilibrium condition is thus presented as:
100 = 650 – 5QA
10
100 = 400 - 3 QB
Solving the above equations simultaneously, we get
QA = 110 and
QB = 90
Therefore, EAL should sell 110 tickets of A type and 90 tickets of B type passengers.
b) Substituting the above quantities in their respective demand functions, we get
PA = 650 – 2.5 QA
= 650 – 2.5 (110)
= $ 375
5
PB = 400 - 3 QB
5
(90)
= 400 - 3 = $ 250
Hence, the EAL should charge $ 375for the A type passengers and $ 250 for the B type
passengers.

239
c) If EAL decides to charge a uniform price, the equilibrium price will be obtained first by
deriving the market demand function and then by using the usual method (MC = MR)
Market demand (Q) = QA + QB
Q = 260 – 0.4 PA + 240 – 0.6 PB
Since prices are uniform PB = PA = P
Thus the market demand equation becomes = 500 – P or
P = 500 – Q
TR = P.Q = 500 Q – Q2
MR = 500 – 2Q
Given MC = 100, Equilibrium occurs when MC = MR, i.e.
100 = 500 – 2Q
Q = 200, and P = 500 – Q = $300
That is, EAL should sell 200 tickets at a price of $ 300 each to maximize its profit .

6.12 Social costs of monopoly: the dead weight loss

In a competitive market, price equals marginal cost of production. Monopoly power, on the other
hand, implies that price exceeds marginal cost. Because monopoly power results in higher prices
and lower quantities produced, we would expect it to make consumers worse off and the firm
better off. But suppose we value the welfare of consumers the same as that of producers. In
aggregate, does monopoly power make consumers and producers better off or worse off?
To answer this question, suppose an industry operating under perfectly competitive situation is
suddenly monopolized. We can answer the questions by comparing the consumer and producer
surplus that results when a competitive industry produces a good with the surplus that results
when a monopolist supplies the entire market.
Referring to the following figure, suppose DD represents the market demand curve, MR
represents the corresponding marginal revenue.

240
p

F
Dead
41 = pm D
weight loss
MC
A B Ec
Em
25 = pc
C
DD= Price = MR (for perfect competitor)
G Em
MR

0 Qm Qc Q
6 10
Fig.6.8
Here, we use consumers’ and producers’ surplus as a measure of welfare of each. Consumer
surplus is the area between the demand curve and equilibrium price and producer surplus is the
area between the equilibrium price and marginal cost curve.
- A perfect competitor’s equilibrium occurs when MC equal price or marginal revenue at
Ec and the equilibrium price and quantity are PC &QC respectively. Here the consumer’s
surplus is the area above the dropped line Pc Ec and below the demand curve i.e. area of
D Pc F Ec. On the other hand the producer surplus is the area below the dropped line
PcEc and above the MC curve.
- A monopolist equilibrium occurs when MC = MR i.e. at Em and the equilibrium price
and quantity become Pm and Qm respectively. Hence, in monopoly lower quantity is sold
at higher price. The new consumers’ welfare is the area above the dropped line PmD and
below the demand curve (i.e. area of DPmFD) whereas the producers surplus becomes the
area below the dropped line PmD and above MC curve to the left of Qm (i.e. the area
GPmDEm)
- Thus monopoly power reduces the consumers’ surplus by the amount which equals area
A+B. But increases the producers’ surplus by the area A-C. The net welfare effect (loss)
is obtained by deducting the welfare loss of consumers from the welfare gain of
producers i.e.,

241
 Net welfare = Welfare gain by producers – Welfare loss by consumers
= A-C – (A+B)
= A-C – A-B
= -C –B or – (C +B)
Thus monopoly results in a welfare loss which is given by the area (C+B)
This area is called dead weight loss. It is gained neither by producers nor by consumers.

The other disadvantage (Social cost) of monopoly is that is discourages innovations. Monopolist
may feel secure and have no incentive to innovate new product (technology) since there are no
competitors.

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 Welfare loss

Monopoly Graph

 A monopolist will seek to maximise profits by setting output where MR =

MC
 This will be at output Qm and Price Pm.
 Compared to a competitive market, the monopolist increases price and
reduces output
 Red area = Supernormal Profit (AR-AC) * Q
 Blue area = Deadweight welfare loss (combined loss of producer and
consumer surplus) compared to a competitive market

243
Disadvantages of a Monopoly

 Higher prices Higher price and lower output than under perfect
competition. This leads to a decline in consumer surplus and a deadweight
welfare loss
 Allocative inefficiency. A monopoly is allocatively inefficient because in
monopoly the price is greater than MC. P > MC. In a competitive market,
the price would be lower and more consumers would benefit
 Productive inefficiency. A monopoly is productively inefficient because it
is not the lowest point on the AC curve.
 X – Inefficiency. It is argued that a monopoly has less incentive to cut
costs because it doesn’t face competition from other firms. Therefore the
AC curve is higher than it should be.
 Supernormal Profit. A monopolist makes supernormal profit Qm * (AR –
AC ) leading to an unequal distribution of income.
 Higher prices to suppliers – A monopoly may use its market power and
pay lower prices to its suppliers. E.g. Supermarkets have been criticised
for paying low prices to farmers.
 Diseconomies of scale – It is possible that if a monopoly gets too big, it
may experience diseconomies of scale. – higher average costs because it
gets too big
 Worse products. Lack of competition may also lead to improved product
innovation.
 Charge higher prices to suppliers. Monopolies may use their
supernormal profits and monopsony power to pay lower prices to
suppliers. For example, supermarkets squeezing prices paid to farmers.
Advantages of monopoly

1. Economies of scale

244
If a firm is in a competitive market and produces at Q2, its average costs will be
AC2. A monopoly can increase output to Q1 and benefit from lower long-run
average costs (AC1). In industries with high fixed costs, it can be more efficient
to have a monopoly than several small firms.
2. Research and development
The supernormal profit can enable more investment in research and
development, leading to better products.

3. Good quality firm

A firm may gain monopoly power because it is very innovative and successful,
e.g. Google, Amazon, Apple. Therefore, monopoly does not always lead to
inefficiency.

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